Exam 22: The Short Run Trade Off Between Inflation and Unemployment: Part A

According to the Phillips curve diagram, if a central bank disinflates what ultimately happens to the unemployment rate?

A central bank disinflates. Output is 4% less for one year, 3% less the next year, and 2% less the third year. If inflation fell by 2 percentage points, what was the sacrifice ratio?

Suppose the price level is 110.00 at the end of 2020, 121.00 at the end of 2021, and 128.26 at the end of 2022. Can we accurately describe the period 2021-2022 as a period of disinflation?

Suppose that the Prime Minister and Parliament of Veridian are disappointed with the high inflation rates under the current system where the Veridian Ministry of Finance is in charge of the money supply. They make reforms to lower inflation from its current rate of 8%. Suppose further that the public is confident that with the reforms in place that inflation will fall to 2%. Also suppose that those in control of the money supply actually conduct monetary policy so that the actual inflation rate is 4%. Using long-run and short-run Phillips curves and assuming the natural rate of unemployment is 6%, show the initial long run equilibrium of Veridian and label it “A”. Assuming that the government had actually set inflation at 2% and that the public believed this, label the long-run equilibrium “B”. Now, suppose that inflation expectations fell to 2% and that the government unexpectedly created inflation of 4%. Show the short-run equilibrium and label it “C”. If the money supply continues to grow at a rate consistent with 4% inflation, show where the economy ends up and label that point “D”.

Suppose that businesses become less optimistic about the future.Assuming no change in inflation expectations,how would the effects of this shock be shown on the Phillips curve diagram and what would happen to inflation and unemployment?

What did Friedman and Phelps predict would happen if policymakers tried to move the economy upward along the Phillips curve? Did the behavior of the economy in the late 1960s and the 1970s prove them wrong?

How is a decrease in the natural rate of unemployment shown in the Phillips curve diagram? Does this decrease change the inflation rate?

Assuming that rational expectations theory does not hold, if a central banks attempts to reduce the inflation rate what happens to the unemployment rate in the short-run?

What would a central bank need to do to reverse the effects of a favorable supply shock on inflation? What would its reaction do to the unemployment rate in the short run?

An increase in the natural rate of unemployment shifts the short-run Phillips curve to the -----.If the central bank sees the increase in the unemployment rate,but thinks the natural rate has remained the same and so wants to reduce unemployment,it would -------- the money supply growth rate.If it maintains this money supply growth rate,eventually the short run Phillips curve will shift ----- and unemployment will be -----.

A central bank raises the money supply growth rate and keeps it at that higher rate. Explain the process by which the economy moves to long-run equilibrium.

How does a central bank’s accommodation of an adverse supply shock change the long-run results of the shock?

What does the natural-rate hypothesis claim?

The Fed increases the money supply growth rate.Assuming inflation expectations remain constant,use a Phillips curve diagram to show the short-run effects of the Fed's policy.

Suppose that the economy is at an inflation rate such that unemployment is above the natural rate. How does the economy return to the natural rate of unemployment if this lower inflation rate persists? Use sticky-wage theory to explain your answer.

If there is a favorable supply shock which direction does the short-run Phillips curve shift? What initially happens to unemployment and inflation as a result of this shock?

Some countries have had relatively high inflation and relatively high unemployment for long periods of time. Is this consistent with the Phillips curve? Defend your answer.

For a given short-run Phillips curve,if expected inflation is 8% but actual inflation is 10%,is the unemployment rate above or below its natural rate?

If there is a decline in business confidence and the Fed desires to return unemployment towards its natural rate, what should it do? If business confidence eventually returns to normal but the Fed does not reverse its policy, what eventually happens to the inflation rate?

Use the sticky-wage theory of aggregate demand to explain the short-run Phillips curve.