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During 2007, the U.S. economy was hit by a price shock when the price of oil...

During 2007, the U.S. economy was hit by a price shock when the price of oil increased from around $60 per barrel to around $130 per barrel by June 2008. While inflation increased during the fall of 2007 (from around 2.5% to 4.0%), unemployment did not change signifi­cantly (it even increased slightly). Explain the relationship between inflation and unemploy­ment in 2007 using the modern Phillips curve concept.

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Phillips curve shows the tradeoff between inflation and unemployment. Unemployment can be reduced only if inflation is allowed to rise.

But such situations of supply shock totally invalidates the Phillips curve hypothesis. There is rise in unemployment and inflation while according to Phillips curve unemployment must come down when inflation is high.

This is a situations of stagflation. Phillips curve does not hold here.

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