Use the information below to explain adjustments that move the economy to a long-run equilibrium. Assume that firms and workers have adaptive expectations

The current unemployment rate = 7%.
The natural rate of unemployment = 5.5%.
Last year's inflation rate = 5%.
This year's inflation rate = 4%.


If firms and workers have adaptive expectations, they will expect inflation this year to be the same as last year (5%). Since workers are overestimating the actual rate of inflation, real wages will be rising, leading to an unemployment rate that is above its natural level (7% > 5.5 %). As firms and workers adjust their inflation expectations, real wages will decrease until the economy reaches its natural rate of unemployment.

Economics

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