Question

Suppose that the economy is experiencing a high level of inflation rate and unemployment is below
the natural rate. How does the economy return to the natural rate of unemployment if this higher
inflation rate persists?

Answer 1

The given scenario of high inflation rate and the unemployment rate to be lower than the natural rate of unemployment, shows that there is an inflationary gap in the economy and there is a demand pull inflation in the economy. It makes cost of production to increase that makes SRAS to shift to the left. When it happens, then potential output level is achieved again and inflationary gap is eliminated. Further, price level also increases and inflation rises to the next level. It makes economy to the go back to the natural rate of unemployment, with persistence of higher inflation rate.  Here, it is to be noted that there is no discretionary fiscal and or monetary intervention in the economy.

When there is a contractionary fiscal and or monetary policy is used, then also, potential output level with natural rate of unemployment is achieved, by AD decreasing and shifting to the left. But, in this case inflation rate decreases. Hence, higher inflation rate cannot persist longer when government and or Fed intervene.