Question

In the past, some people believed that the Fed routinely expanded the money supply during presidential election years to help the incumbent president. For this question, assume that the Fed allows inflation to be 3% in every presidential election year instead
of 2% in other years. If people form expectations adaptively, their expectations will ________ inflation so expansionary policy will____________.

Overestimate ; reduce the unemployment rate.

Overestimate ; increase the unemployment rate

Underestimate ; increase the unemployment rate

underestimate ; reduce the unemployment rate.

accurately estimate ; not change the unemployment rate

Answer 1

Adaptive expectations is a hypothesized process by which people form their expectations about what will happen in the future based on what has happened in the past. For example, if inflation has been higher than expected in the past, people would revise expectations for the future. So if people form expectations adaptively, their expectations will underestimate inflation (they think inflation will be 2 but it is 3% in election years)

Economists have observed an inverse relationship between the unemployment rate and the inflation rate, since they have underestimated the inflation rate so expansionary policy will increase the unemployment rate.