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Assume that an economy starts at a long-run equilibrium with a natural rate of unemployment equal to 6 percent and an inflation rate of 10 percent.

Assume that an economy starts at a long-run equilibrium with a natural rate of unemployment equal to 6 percent and an inflation rate of 10 percent. Assume that there is a short-run tradeoff between inflation and unemployment as described by a Phillips curve. Use the Phillips curve to graphically illustrate why a central bank that desires both low inflation and low unemployment has the incentive to renege on an announced policy to reduce inflation to 3 percent, if people set wages and prices on the expectation of 3 percent inflation and the central bank has the discretion to change its monetary policy after these expectations are set.

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Since expectations are formed rationally and the policy is credible, the Phillips curve will
immediately shift upward to the right. In both the short run and the long run, the inflation rate...

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