Chapter 16: Expectations Theory and the Economy

Question 1

Phillips Curve

Answer 1

A curve that originally showed the relationship between wage inflation and unemployment and that now more often shows the relationship between price inflation and unemployment.

Question 2

Relationship between money wage rates and unemployment rates

Answer 2

Inverse relationship

Question 3

What does the inverse relationship between money wage rates and unemployment rates suggest

Answer 3

A trade-off between wage inflation and unemployment.
Higher wage inflation means lower unemployment; lower wage inflation means higher unemployment.
The combination of low wage inflation and low unemployment is unlikely.
Both lowering wage inflation and unemployment is impossible.

Question 4

Stagflation

Answer 4

The simultaneous occurrence of high rates of inflation and unemployment.

Question 5

2 Phillips curves

Answer 5

• Short-run Phillips curve

- Long-run Phillips curve

Question 6

Milton Friedman on the tradeoff between inflation and unemployment

Answer 6

There is a trade-off in the short run but not in the long run.

Question 7

Friedman Natural Rate Theory

Answer 7

Within the Phillips curve framework, the idea that, in the long run, unemployment is at its natural rate and that there is a long-run Phillips curve, which is vertical ath the natural rate of unemployment.

Question 8

2 Points in the Friedman Natural Rate Theory

Answer 8

• Wages and Rates are flexible

- Expectations are formed adaptively.

Question 9

Adaptive Expectations

Answer 9

Expectations that individuals form from past experience and modify slowly as the present and the future become the past.

Question 10

Rational Expectations

Answer 10

Expectations that individuals form based on past experience and on their predictions about the effects of present and future policy actions and events.

Question 11

Policy Ineffectiveness Proposition (PIP)

Answer 11

If (1) a policy change is correctly anticipated, (2) individuals form their expectations rationally, and (3) wages and prices are flexible, then neither fiscal policy nor monetary policy is effective at meeting macroeconomic goals.

Question 12

4 Cases in New Classical theory

Answer 12

1: Policy Correctly Anticipated
2: Policy Incorrectly Anticipated (Bias Upward)
3: Policy Incorrectly Anticipated (Bias Downward)
4: Policy Unanticipated