Question

Consider a hypothetical economy that is at a short run and long run equilibrium. Suppose that in this economy, there is an adverse (i.e. negative) supply shock. Additionally, there is an increase in people’s expectations about future inflation. Considering the Phillips Curve, answer what will happen to:
i)    The inflation rate.
ii)    The unemployment rate.

In the short-run for such an economy.

		Inflation will increase; unemployment will increase.
		Inflation will decrease; unemployment will decrease.
		Inflation will increase; unemployment will decrease.
		Inflation will increase; the effect on unemployment is uncertain.

Answer 1

Answer : The answer is option D.

Adverse supply shock shift the short-run aggregate supply curve to leftward. This increase the inflation rate and decrease the real GDP. At the same time due to people's expectation about future inflation the aggregate demand increase which shift the aggregate demand curve to rightward. This increase the inflation rate and also increase the real GDP. As at the same time the aggregate supply decreases and aggregate demand increases hence the inflation rate will increase but the changes in real GDP is uncertain. Hence based on Philips Curve the inflation rate will increase but the effects on unemployment rate become uncertain. Hence except option D other options are not correct. Therefore, option D is the correct answer.