Question

Refer to Figure Inflation

Answer 1

Phillips curve shows inverse relationship between inflation rate and unemployment rate.

Inflation at time t (p_t) is a function inversely related to Unemployment and expected inflation at time t:
p_t = f (1/U) + (pe_t).

According to expected inflation model, we know that:

p_t = p_t-1

In this case, economy was initially at point a, where inflation is 0% and unemployment is 7%. Government feels that 7% unemployment is too high. So government tries to reduce unemployment by increasing government expenditure. So economy moves from point a to b (Movement along SRPC₁ ). But by using adaptive expectations, the economy expects same 3% and thereby without any of the government interventions, the Phillips curve shifts right ie. SRPC₂. And thereby economy reaches at point c Where inflation is 3% and unemployment is same 7%.
But next time, expected inflation was 2%, and thus SRPC₂ shifts to SPRC₃. There is an increase in inflation by 2% but in long run, unemployment reaches the same point of 7%.
The level of the Phillips curve depends on the expected rate of inflation. When the expected rate of inflation rises from 3% to 5% the curve shifts rightward from SRPC₂ to SRPC₃. The natural rate of unemployment ie 7% is then associated with the higher equilibrium inflation rate ie 5%.
Thus,expected rate of inflation along SRPC2 is 2%
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