Real Wage Stability on the PS Curve During an Inflationary Spiral

Analyzing an Inflationary Spiral

An economy experiences a sustained period where the unemployment rate is held consistently below the level that would normally keep inflation constant. If workers and firms form their expectations about future inflation based on the inflation rate of the previous period, what is the most likely outcome for the inflation rate over several consecutive periods?

An economy starts at its inflation-stabilizing unemployment rate. A government stimulus then causes unemployment to fall and remain below this rate for several periods. Arrange the following events to show the causal chain that leads to continuously rising inflation, assuming expectations are based on the previous period's inflation.

In an economy where unemployment is persistently below the inflation-stabilizing rate, the resulting positive bargaining gap is, by itself, sufficient to cause inflation to increase year after year.