THE PHILLIPS CURVE IN THE SHORT RUN AND LONG RUN ECONOMICS ANSWER...

The Phillips curve in the short run and long run In the year 2020, aggregate demand and aggregate supply in the fictional country of Marjan are represented by the curves and AS on the following graph. Suppose the natural rate of output in this economy is $6 trillion. On the following graph, use the green line (triangle symbol) to plot the long-run aggregate supply (LRAS) curve for this economy. Economists have forecast that if the government does nothing and the economy continues to grow at the current rate, aggregate demand in 2021 will be given by the ADA curve, resulting in the outcome illustrated by point A. If the government pursues an expansionary policy, aggregate demand in 2021 will be given by the ADB curve, resulting in the outcome illustrated by point B. The following table gives projections for the unemployment rates that would occur at point A and point B. Consider what the rate of inflation would be between 2020 and 2021, depending on whether the economy moves from the initial price level of 102 to the price level at outcome A or the price level at outcome B. Complete the table by entering the inflation rate at each potential outcome point. Note: Calculate the inflation rate to two decimal points of precision. Unemployment Rate Inflation Rate A 7% B 5% The short-run Phillips curve is (a vertical/an upward-sloping/a downward-sloping) line: At the natural rate of output At the natural rate of unemployment Representing the tradeoff between unemployment and inflation Now consider the long-run effects of this policy. Suppose, in particular, that following implementation of the policy, the aggregate demand curve remains at ADB . Designate the long-run equilibrium that would follow such a policy as outcome C. Going back to the first graph, place the grey point (star symbol) at outcome C. Because output at point C is (greater than/equal to/less than) the natural rate of output, the unemployment rate associated with outcome C is (greater than/equal to/less than) the natural rate of unemployment. Finally, use the green line (triangle symbol) to draw the long-run Phillips curve (LRPC) on the second graph. This line is (a vertical/an upward-sloping/a downward-sloping) line: At the natural rate of output Representing the tradeoff between unemployment and inflation At the natural rate of unemployment The long-run effects of monetary policy The following graphs show the state of an economy that is currently in long-run equilibrium. The first graph shows the aggregate demand (AD) and long-run aggregate supply (LRAS) curves. The second shows the long-run and short-run Phillips curves (LRPC and SRPC). Which of the following statements are true based on the previous graphs? Check all that apply. It is impossible to determine the natural rate of unemployment from these graphs alone. The natural rate of output is 6%. The natural rate of unemployment is 6%. Suppose the central bank of the economy increases the money supply. Show the long-run effects of this policy on both of the graphs by shifting the appropriate curves. The long-run effect of the central bank’s policy is (an increase/no change/a decrease) in the inflation rate, (an increase/no change/a decrease) in the unemployment rate, and (an increase/no change/a decrease) in real GDP. 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 increase 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. Hint: You may assume that the central bank’s move was unanticipated. In the short run, an unexpected increase in the money supply results in (an increase/no change/a decrease) in the inflation rate and (an increase/no change/a decrease) in the unemployment rate. On the following graph, shift the curve or drag the blue point along the curve, or do both, to show the long-run effects of the increase in the money supply. In the long run, the increase in the money supply results in (an increase/no change/a decrease) in the inflation rate and (an increase/no change/a decrease) in the unemployment rate (relative to the economy’s initial equilibrium). The Phillips curve in the late 20th century The following table shows selected data on unemployment and inflation in the United States between 1974 and 1978. Year Unemployment Rate Inflation Rate (Percent) (Percent) 1974 5.6 11.0 1975 8.5 9.1 1976 7.7 5.8 1977 7.1 6.5 1978 6.1 7.6 Plot the data for these five years on the following graph. Note: You will not be graded on how you plot the points, but plotting the points accurately on the graph will allow you to examine the relationship between unemployment and inflation during this period and solve the problems that follow. Which of the following statements best describes the relationship between inflation and unemployment in the United States during this time period? The short-run Phillips curve remained stable. The short-run Phillips curve shifted to the left after actual inflation was lower than expected. The short-run Phillips curve shifted to the right after actual inflation was higher than expected. The following graph shows the short-run Phillips curve (SRPC) for the United States in 1974. Expectations and the Phillips curve The following graph shows an economy in long-run equilibrium at point A (grey star symbol). The vertical line is the long-run Phillips curve (LRPC). The downward-sloping curve labeled SRPC1 is the short-run Phillips curve passing through point A. Which of the following is true along SRPC1 ? The actual unemployment rate is 6%. The natural rate of unemployment is 3%. The expected inflation rate is 5%. The actual inflation rate is 5%. Suppose that the Fed suddenly and unexpectedly decreases the money supply in an effort to reduce inflation. As a result of this unanticipated action, actual inflation falls to 3%. On the previous graph, use the black point (plus symbol labeled “B”) to illustrate the short-run effects of this policy. Now, suppose that—after a period of 3% inflation—households and firms begin to expect that the inflation rate will continue to be 3%. On the previous graph, use the purple line (diamond symbol) to draw SRPC2 , the short-run Phillips curve that is consistent with these expectations, assuming that it is parallel to SRPC1 Finally, using the orange point (square symbol labeled “C”), indicate on the previous graph the new, long-run equilibrium for this economy. The inflation rate at point C is (higher than/the same as/lower than) the inflation rate at point A, and the unemployment rate at point C is (higher than/the same as/lower than) the unemployment rate at point A. Was the Fed able to achieve its goal of lowering inflation? Yes, but only in the short run; in the long run, inflation returned to its natural rate. Yes, the Fed’s policy successfully reduced inflation in both the short run and the long run. No, because the Fed cannot affect the inflation rate through monetary policy. Now, suppose that the public fully anticipates the Fed’s decision to decrease the money supply. Assume the public also believes that the Fed is firmly committed to carrying out this policy. According to rational expectations theory, when the economy is in long-run equilibrium, a fully anticipated decrease in the money supply will cause the economy to move (from A to B permanently/from A to B to C and then back to B/from A to B and then back to A/from A to B and then to C/directly from A to C) on the previous Phillips curve graph. In this case, rational expectations theory predicts that the fully anticipated decrease in the money supply will have the immediate effect of (an increase/no change/a decrease) in the inflation rate and (an increase/no change/a decrease) in the unemployment rate. The costs of disinflation The following graph depicts the short-run and long-run Phillips curves (SRPC and LRPC) for a hypothetical economy in long-run macroeconomic equilibrium at point A, where the natural unemployment rate is 6% and the current inflation rate is 8% per year. Suppose that the central bank in this economy is concerned that inflation is too high and wants to lower the inflation rate by 6 percentage points per year. A reduction in the rate of inflation is known as (deflation/disinflation) . To reduce inflation from 8% to 2% in the short run, the central bank would have to accept an unemployment rate of % True or False: If people have rational expectations, the sacrifice ratio could be much higher than suggested by the short-run Phillips curve. True False