Question

Suppose expected inflation rate ($\pi^e_t$) of an individual is formed as:
$\pi^{e}_t = (1 − \theta) \overline{\pi} + \theta \pi_{𝑡−1}$
where, $\overline{\pi} $ is constant inflation rate, $\pi_{t−1}$ is previous year’s inflation rate, and $ 0 \leq \theta \leq 1$ is weight assigned to inflation rate at different points in time.
Then, which of the following is NOT CORRECT?

• A. If $\theta = 0$, then the individual assumes a constant inflation rate
• B. If $\theta \approx 1$ and $\overline{\pi} < \pi_{𝑡−1} $, then the individual expects this year’s inflation rate to be similar to last year
• C. The original Phillips curve is derived under the assumption of $\theta \approx 1$
• D. A modified Phillips curve is derived under the assumption of $\theta = 1$

Answer 1

The Correct Option is C

Analysis of the Phillips Curve and Expectations 

Step 1: Understanding the Original Phillips Curve

The original Phillips curve assumes that inflation is directly related to unemployment.

However, the formulation of expectations in the original Phillips curve does not require θ ≈ 1.

Step 2: Expectations in the Phillips Curve

• The original Phillips curve assumes that expectations adjust based on general economic conditions.
• It does not necessarily rely only on past inflation.

Step 3: Identifying the Incorrect Statement

Option (C) is incorrect because it assumes that θ ≈ 1 is a necessary condition in the original Phillips curve.

Conclusion:

The assumption of θ ≈ 1 does not specifically apply to the original Phillips curve, making option (C) incorrect.