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Is this TRUE or FALSE, please?  Suppose that expected inflation is 5% and thus,...

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lilylee | Student, College Freshman

Posted June 25, 2013 at 10:37 PM via web

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Is this TRUE or FALSE, please? 

Suppose that expected inflation is 5% and thus, nominal wages rise, along with all other input price by 5%. Suppose also, that actual inflation over this period was only 2%.

In terms of the behavior of the short-run aggregate supply curve, it would shift up given the expectation of higher inflation and then shift downward to adjust for the actual rate of inflation.

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Kay Morse | College Teacher | (Level 1) Senior Educator

Posted June 26, 2013 at 10:26 PM (Answer #1)

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According to Edmund Phelps' Philips Curve (Nobel Prize in Economics 2006), actual inflational equals both expected inflation (here 5%) plus the Constant times the difference between actual unemployment and natural unemployment (natural unemployment: where inflation is stable and employment is virtually full employment), the unemployment gap. Here actual inflation is 2%.

In terms of the aggregate supply curve, inflationary prices cause short-run contraction (inward, not "upward") of aggregate supply. So expected inflation of 5% would cause short-run expansion.

 

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Karen P.L. Hardison | College Teacher | eNotes Employee

Posted June 27, 2013 at 10:29 PM (Answer #2)

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Lelt's try some definitions first before trying to solve your economics puzzle.

Expected inflation is the public expectation of what future inflation will be as a result of a Federal policy decision. Expected inflation provides a secondary cause to inflation.

Actual inflation is a calculation of the change in the Consumer Price Index for target years and has primary causes from consumer demand and cost push.

Aggregate supply curve shows the relationship between price level (which can be pushed up by inflation) and national output. In the short run, if prices rise and shift upward due to inflation, then the curve moves inward.

Thus, if prices move in a rise upward, the AS curve will move inward. Expected inflation has a secondary effect. Actual inflation may be delayed in being perceived in the market place because of "inflation illusion" precipitated by expected inflated higher price levels.

In the short run, a rise in price level and in wages corresponds to a rise in inflation expectations that results in an inward movement of the AS curve. If a correction to an actual inflation rate level occurs with falling price and wage levels, then the AS curve will move outward.

So your statement is false as the AS curve moves inward and outward in relation to (rising or falling) price levels and national output. The AS curve does not move upward and downward, though your question does show the correct (True) correspondence between rising/falling (inflation, wage) and contraction/expansion of the aggregate supply curve.

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