If expectations about inflation are formed as per the rational expectations hypothesis, then the short-run Philips curve will be
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1 mark, −0.333MacroeconomicsBusiness cycles and rational expectationsRational expectations and the Lucas critiqueModerateabout 2 min
GATE 2021 Question 18: Business cycles and rational expectations
Answer and worked solution
Answer: (B)
Under rational expectations, agents correctly and immediately incorporate all available information — including the systematic behavior of monetary/fiscal policy — into their inflation expectations. This means any anticipated (systematic, rule-based) policy action fails to create a real surprise, and therefore fails to move real output or unemployment away from the natural rate, even in the short run (this is the New Classical 'Policy Ineffectiveness Proposition').
Since unemployment doesn't deviate from the natural rate regardless of the (anticipated) inflation rate, the short-run Phillips curve becomes vertical — a vertical line at the natural rate of unemployment on the horizontal axis, i.e., parallel to the vertical (inflation) axis.
Therefore the answer is (B).
The trap: (A) negatively sloped
Students who default to the standard textbook 'short-run Phillips curve is downward-sloping' fact (true under ADAPTIVE expectations, where surprises can move unemployment temporarily) may not register that the question specifically asks about RATIONAL expectations, under which the short-run curve collapses to vertical — the same shape usually reserved for the long run under adaptive expectations.
Business cycles and rational expectations has come up 21 times in 5 exams since 2010.
What this question tests
This question is on Rational expectations and the Lucas critique, part of Business cycles and rational expectations in Macroeconomics.
How expectations formed with all available information change what policy can do.
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Question from the GATE 2021 paper. Solutions are TestStop's own. Not affiliated with or endorsed by any examination authority.