An increase in the expected rate of inflation

Solution

The Phillips curve gives the relationship between the country's inflation rate and its unemployment rate at a given set of inflationary expectations. An unexpected expansion of aggregate demand will reduce the rate of unemployment because wage and price setters do not increase wages and prices all the way to the new long-run equilibrium. In the long-run when workers and firms realize that aggregate demand has increased wages and prices will rise all the way and the Phillips curve will shift up to the point where the new inflation rate will be consistent with the natural rate of unemployment. Any expectation of an increase in the inflation rate will cause the Phillips curve to shift up; a higher rate of inflation will be consistent with each level of unemployment.