Question

5. Monetary policy and the Phillips curve 

The following graph shows the current short-run Phillips curve for a hypothetical economy; the point on the graph shows the initial unemployment rate and inflation rate. Assume that the economy is currently in long-run equilibrium. 

Suppose the central bank of the hypothetical economy decides to decrease the money supply. 

On the following graph, shift the curve or drag the blue point along the curve, or do both, to show the short-run effects of this policy. 

 In the long run, the decrease in the money supply results in _______  in the inflation rate and_______  in the unemployment rate (relative to the economy's initial equilibrium).

 

Answer 1

Phillips curve is the curve that explains the relationship between the inflation rate and the unemployment rate in the economy. Movement along the Phillips curve explains the change in the aggregate demand in the economy.
Here, it is given that the money supply decreases in the economy; it will decrease the money holdings by the people due to which demand for products and services will decrease in the economy and producers reduces the employment opportunities. As a result, the price level decreases in the short-run that, in turn, decreases the inflation rate. Hence, there will be downward movement along the Phillips curve as shown in the graph:

Therefore, in the short-run, an unexpected decrease in the money supply results in a decrease in the inflation rate and an increase in the unemployment rate.
In the long-run, an economy is assumed to be at full employment level. To increase the employment level, the government will use expansionary fiscal policy to increase the aggregate demand and employment opportunity. Increased demand will increase the price level, which further leads to an increase in the inflation rate. As a result, the employment rate and inflation rate achieved its earlier level at the Phillips curve, as shown in the graph below: