You are studying abroad in Australia for a semester. Unemployment has been creep

Question

You are studying abroad in Australia for a semester. Unemployment has been creeping up and currently stands at 6%. This rate is getting a little too high for comfort, so the central bank of Australia decides to do something about it. When you arrived in the country, inflation was hovering around 3% and had been at that level for a few years. The central bank’s action leads inflation to increase to 5%.

A. What happens to unemployment in the short run if inflation is expected to be 0%? [it rises, it falls, or it remains the same]

B. What happens to unemployment in the short run if citizens of Australia have adaptive expectations? [it rises, it falls, or it remains the same]

C. What happens to unemployment in the short run if citizens of Australia have rational expectations? [it rises, it falls, or it remains the same]

Explanation / Answer

Policy will be effective if it is unanticipated it means that the policy will show the effects if it results in something that is different from the expectation.

A. We know that even in the short run if the inflation is expected to be 0% but actually increases to 5% it means the policy of central bank result in devaition of the expectation so it leads to have impact on unemployement and the unemployment level will fall as inflation rises because if the rate of inflation exceed the expectation of inflation it leads to reduce the unemployment .

B. In the short run, if the citizens of Australia have adaptive expectation so it means they will made their expectations according to the past data and inflation was hovering around 3% and had been at that level for a few years so the citizens will expect the inflation rate this year to be 3% but actually due to central bank's action inflation become 5% again the actual inflation exceed the expected inflation so it will have an impact on unmployment and unemployment will Fall.

C. If the citizen of Australia have rational expectation, rational expectation involves the future actions to predict the inflation so they anticipate that unemployment rate is high and central bank will use monetary policy (expansionary monetary policy) to reduce the rate of unemployment which leads to increase inflation. As we know that policy is only effective if it is unanticipated but citizens of Australia already expect the inflation to increase so an increase in inflation will have no effect on unemployment as the change is already anticipated. It means the Unemployment rate remains the same.

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