Question

Monetary Policy in Mokania Mokania has had inflation of 15% for many years. Mokania establishes a new central bank, the Bank of Mokania, with the hopes of reducing the inflation rate. The Bank of Mokania publicizes that it intends to reduce the inflation rate to 5%. If it actually reduces inflation to 3% and people were expecting inflation to fall only to 8%, then:
a. unemployment falls but it would have fallen by less if the Bank of Mokania had reduced inflation to 5% rather than 3%.
b. unemployment rises but it would have risen by less if the Bank of Mokania had reduced inflation to 5% rather than 3%.
c. unemployment falls but it would have fallen by more if the Bank of Mokania had reduced inflation to 5% rather than 3%.
d. unemployment rises but it would have risen by more if the Bank of Mokania had reduced inflation to 5% rather than 3%.

Answer 1

Answer: b. unemployment rises but it would have risen by less if the Bank of Mokania had reduced inflation to 5% rather than 3%

Explanation:

There exists and inverse relationship between the unemployment rate and the inflation rate with the logic being that higher inflation means that the economy is doing better and people have more jobs and are demanding more goods and services hence the inflation.

If the inflation drops more than people were expecting it to therefore, unemployment would rise. As mentioned above, inflation and unemployment are negatively correlated so the more the fall in inflation, the higher the unemployment rate.

A fall in inflation to 3% would therefore mean a higher rise in employment than a fall in inflation to 5% which is less of a fall and so will lead to a smaller rise in unemployment.