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Suppose the Federal Reserve’s policy is to maintain low and stable inflation by keeping unemployment at its natural rate. However, the Fed believes that the natural rate of unemployment is 4 percent when the actual natural rate is 5 percent. If the Fed based its policy decisions on its belief, what would happen to the economy? How might the Fed come to realize that its belief about the natural rate was mistaken?

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Principles of Economics (MindTap C...

8th Edition
N. Gregory Mankiw
Publisher: Cengage Learning
ISBN: 9781305585126

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BuyFindarrow_forward

Principles of Economics (MindTap C...

8th Edition
N. Gregory Mankiw
Publisher: Cengage Learning
ISBN: 9781305585126
Chapter 35, Problem 6PA
Textbook Problem
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Suppose the Federal Reserve’s policy is to maintain low and stable inflation by keeping unemployment at its natural rate. However, the Fed believes that the natural rate of unemployment is 4 percent when the actual natural rate is 5 percent. If the Fed based its policy decisions on its belief, what would happen to the economy? How might the Fed come to realize that its belief about the natural rate was mistaken?

To determine
The Fed’s perspective about natural rate of unemployment.

Explanation of Solution

The Fed believes that the natural rate of employment is 4 percent, but the actual natural rate of unemployment is 5 percent. If the Fed based its policy decisions on its belief, its effect on the economy can be explained with the help of a figure as shown below.

Figure 1 shows the changes in inflation rate.

In Figure 1, the vertical axis measures inflation rate and the horizontal axis measures unemployment rate. SRPC shows the shift in the short run Phillips curve and the vertical curve is the long run Phillips curve. At the starting point on the long run Phillips curve with 5 percent unemployment rate, the Fed believes that the economy is in recession...

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