Question:

Suppose expected inflation rate ($\pi^e_t$) of an individual is formed as:
$\pi^{e}_t = (1 βˆ’ \theta) \overline{\pi} + \theta \pi_{π‘‘βˆ’1}$
where, $\overline{\pi} $ is constant inflation rate, $\pi_{tβˆ’1}$ 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?

Updated On: Feb 10, 2025
  • If $\theta = 0$, then the individual assumes a constant inflation rate
  • If $\theta \approx 1$ and $\overline{\pi} < \pi_{π‘‘βˆ’1} $, then the individual expects this year’s inflation rate to be similar to last year
  • The original Phillips curve is derived under the assumption of $\theta \approx 1$
  • A modified Phillips curve is derived under the assumption of $\theta = 1$
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The Correct Option is C

Solution and Explanation

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 ΞΈ β‰ˆ 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 ΞΈ β‰ˆ 1 is a necessary condition in the original Phillips curve.

Conclusion:

The assumption of ΞΈ β‰ˆ 1 does not specifically apply to the original Phillips curve, making option (C) incorrect.

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