Discuss the effects of an unexpected decrease in the inflation rate policy on unemployment in the short run. If the reduction in inflation is permanent, what happens in the long run?
What will be an ideal response?
If the reduction in inflation is unexpected, people do not revise their expected inflation rate. As a result, the short-run Phillips curve does not shift so that when the inflation rate is unexpectedly reduced, the economy moves along its (stationary) short-run Phillips curve. Thus the reduction in inflation is associated with an increase in unemployment. If the reduction in inflation is permanent, then as time passes, people revise downward their expected inflation rate. The short-run Phillips curve shifts downward and the unemployment rate falls. When all the adjustments are complete, people will have revised their expected inflation rate so that it equals the new, lower inflation rate. At this time, the unemployment rate will have fallen from its initial increase so that ultimately the unemployment rate equals the natural unemployment rate.
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