Question

Suppose the short run Phillips Curve is given by: Inflation = Expected Inflation +.2 -4*Unemployment Rate Assume that initially, people expect zero inflation. Draw the short run Phillips Curve and the long run Phillips Curve on a graph On the graph, represent what would happen in the short run if the government decided to run 4% inflation (setting inflation =0.04). . On the graph, represent what would happen in the long run if the government decided to run 4% inflation.

Answer 1

Solution :

Short run Phillips curve ( SRPC) :

Inflation(π) = Expected Inflation + 0.2-4* Unemployment rate.

π = πe + .2 - 4*u

(a) :- Expected Inflation (πe) = 0

Then SRPC : Inflation = 0.2 - 4*u

At natural rate of Unemployment

π = πe, so, 0.2 = 4u

Unemployment rate = 0.2/4 = 0.05 = 5%

so, Long run Phillips curve( LRPC) is Vertical at 5%.

(b) :- If govt needs to runs 4% inflation = 0.04

Then 0.04 = 0.2 - 4*u

4u = 0.2 - 0.04 = 0.16

U* = 0.16/4 = 0.04 = 4%

Thus Unemployment rate falls below natural rate by 1%>

(c) :- In long run, SRPC will shift upwards in a way , that SRPC cuts LRPC at 4% inflation rate, thus in long run economy will be at LRPC where unemployment rate is back to its natural level of 5% with permanently higher inflation of 4%.

-0.2 LRPC TT -0.1 SRPC 0 0.02 u 0.04 .05 0.06

LRPC -0.2 TT New SRPC -0.1- (5%,4% 0 0.02 u 0.04