If firms and workers have adaptive expectations, what impact will contractionary monetary policy have on inflation, unemployment, and the Phillips curve?
What will be an ideal response?
Adaptive expectations exist when firms and workers expect inflation in the current time period to be the same as inflation in the previous time period. If the Federal Reserve follows a contractionary monetary policy, inflation will fall. If expectations about inflation are adaptive, the contractionary monetary policy will decrease actual inflation below expected inflation. With no adjustment in nominal wages, the real wage will rise, and the unemployment rate will be pushed above its natural rate. In other words, the inflation rate and the unemployment rate will be negatively related, as indicated by a short-run Phillips curve.
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