Question

Suppose the Federal Reserve’s policy is to maintain low and stable inflation by keeping unemploymentatitsnaturalrate.However,the Fed believes that the natural rate of unemployment is 4 percent when the actual natural rate is 5 percent. If the Fed based its policy decisions on its belief, what would happen to the economy? How might the Fed come to realize that its belief about the natural rate was mistaken?

Answer 1

Since actual rate is 5% and Fed believes that the the long run natural rate is 4%, it will mistakenly believe that the current unemployment rate of 5% exceeds its natural rate of 4% and there is a recession. It then uses monetary expansion which implies that there is an increase in the current inflation rate and a reduction in rate of unemployment which falls to 4% (Fed's belief of natural rate).

As price rises, firms will revise their expectations and so expected inflation will rise further, shifting the Phillips curve up. This raises the rate of inflation further causing an inflation spiral. When the Fed observes this rising trend of inflation it will realize its mistake.