35 the short run tradeoff between inflation and unemployment

CHAPTER 35 SHORT-RUN TRADE-OFF p.807 – 808 Recall that Actual unemployment = natural unemployment – a (actual inflation – expected inflation) In each situation a The actual inflation is higher than expected inflation then actual unemployment is lower than natural unemployment b Conversely, the actual unemployment is higher than natural unemployment c The actual inflation is equal to expected inflation then the actual unemployment is equal to natural unemployment d Similarly, but with lower inflation rate Illustrate the effects of the following developments on both the short-run and long-run Phillip curves Give the economic reasoning underlying your answers (by diagrams) a A rise in the natural rate of unemployment will shift the LPC to the right and also shift the SPC to the right because the unemployment rate is higher at any given inflation rate b A decline in the price of imported oil will lower the expected inflation in short-run then shift the SPC to the left but the expected inflation will adjust and unemployment rate will go back to natural rate There will be no shift in LPC c A rise in government spending increase the AD in short-run ADC shifts to the right and increases price level and output Meanwhile the inflation rate is higher, the unemployment is lower The economy moves upwards along SPC Over the time, the expectations adjust and the unemployment returns to the natural rate There’s no change in LPC d A decline in expected inflation will shift the SPC to the left Over the time, the expectations adjust and unemployment rate returns to natural rate There’s no change in LPC Suppose that a fall in consumer spending causes a recession a AD shifts to the left from AD1 to AD2 The price level decreases and output decreases, which lead to lower inflation rate and higher unemployment rate from A to B The equilibrium moves downward along the SPC b Over time expectations adjust, SAS shifts to the right The equilibrium now is at C, with natural rate of output and lower price level In respond to SAS shifting rightward, SPC shifts leftward to cut the LPC at C The unemployment rate returns at lower inflation rate After the recession is over, the economy faces a better set of inflation and unemployment Suppose the economy is in a long-run equilibrium a b AD shifts to the left in reaction to business pessimism Both price level and output decreases, which means inflation rate decreases while unemployment increases The equilibrium point on SPC moves down the SPC from A to B If Fed undertakes expansionary monetary policy, it might return AD curve and therefore restore the original inflation rate and unemployment rate c Due to the supply shock, the SAS shifts to the left The price level increases and output decreases The inlfation rate is higher higher at any given unemployment rate The SPC shifts to right After this supply shock, if Fed undertakes expansionary monetary policy to shift the AD to right, the price level will increase and so will output The inflation rate will increase but the unemployment rate will decrease Fed cannot return the economy to its initial set of inflation and unemployment Conversely, if the Fed undertakes contractionary monetary policy to shift the AD to the left, the price level will decrease and the output will decrease as well The inflation rate will decrease and the unemployment will increase The equilibrium point will move down the SPC The situation is even worse after Fed’s intervention The situation differs from that in part B because there was no shift in SAS in part B Therefore, the equilibrium point just moves along SPC and can be reversed to original position by monetary policy that influences AD The initial effect of the money growth contraction policy is a leftward shift of AD, which decreases price level and holds back inflation rate but in same time, decreases output and thereby increases unemployment When people get used to the change in inflation rate, the expected inflation rate would shrink, AS shifts to the right and the output increases Accordantly, when the expected inflation is lower, the PC shifts to the left, which means unemployment rate decreases Therefore, if the expectations of people adjust quickly in respond to the new released policy, the effect of temporarily high unemployment will be insignificant It implies that economist Milton, who believes that expectations of inflation change quickly will be more favor of this policy Suppose the Federal Reserve’s policy is policy is to maintain low and stable inflation by keeping unemployment at its natural rate Recall that Actual unemployment = natural unemployment – a (actual inflation – expected inflation The actual unemployment rate is but Fed suppose Fed believes the economy is in a recession then they would implement an expansionary monetary policy… move upward along PC… inflation increases Over time, expected inflation will adjust, PC shifts to the right, end up with higher inflation… but unemployment still … natural… Cannot be changed lead to only to inflation… realize mistake… Suppose the Fed announced that it would pursue contractionary monetary policy to reduce inflation rate a Wage contracts have short durations In this situation, the wage will rapidly adjust to the lower price level and shifts the AS to the right The output returns The recession is less severe b little confidence in the Fed’s determination to reduce inflation Expectations will be sluggish AS will slowly shifts which implies a more severe recession c expectations of inflation adjust quickly to actual inflation Similarly to a, less severe Any policy will face a trade-off of unemployment and inflation The outcome of this policy is also not definite or in other case, the cost of output decrease is too large then not all presidents will support efforts to reduce inflation Politicians might not be objective to the economic target Instead, they are likely to draw the public’s attention to some particular performances such as inflation rate Their effort of solely stabilize inflation can significantly reduce output and increase unemployment rate a It has ambiguous effects on price level However, output falls, unemployment rate rises significantly and inflation rate is higher at any given unemployment rate b expansionary policy to increase AD c because sometimes the cost of inflation is too high 10 minimal wage, union power, efficiency wage, frictional unemployment ... AD curve and therefore restore the original inflation rate and unemployment rate c Due to the supply shock, the SAS shifts to the left The price level increases and output decreases The inlfation... monetary policy to shift the AD to the left, the price level will decrease and the output will decrease as well The inflation rate will decrease and the unemployment will increase The equilibrium point... AS shifts to the right and the output increases Accordantly, when the expected inflation is lower, the PC shifts to the left, which means unemployment rate decreases Therefore, if the expectations