Q3. Suppose the government misjudges... [FREE SOLUTION]

Chapter 18: Q3. (page 388)

Suppose the government misjudges the natural rate of unemployment to be much lower than it actually is and, thus, undertakes expansionary fiscal and monetary policies to lower it. Use the concept of the short-run Phillips Curve to explain why these policies might at first succeed. Use the concept of the long-run Phillips Curve to explain these policies鈥� long-run outcomes.

Short Answer

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The expansionary fiscal and monetary policies would be able to reduce the unemployment rate and increase the inflation rate in the short run as the Phillips curve is negatively sloped in the short run. However, these policies would only increase the inflation rate without changing the unemployment rate as the long-run Phillips curve is vertical.

Step by step solution

Definition of Phillips curve

The Phillips curve (PC) seeks to establish a relationship between inflation and unemployment rates. The PC is negatively sloped in the short run, which defines an inverse relationship between the two variables. In contrast, in the long run, the curve is vertical at the natural rate of unemployment.

Effectiveness of the policies in the short run

The short-run Philips curve (SRPC) is negatively sloped. It implies a trade-off between the unemployment rate and the inflation rate in the short run. Suppose the government adopts expansionary monetary or fiscal policies to boost economic growth.In that case, it will cause the aggregate demand curve to shift rightward, leading to a rise in price and output levels.

Therefore, as the price level rises, the unemployment level falls. So, the negatively sloped SRPC suggests that the government policies would reduce the unemployment rate at the cost of a rise in the inflation rate.

Effectiveness of the policies in the long run

The long-run Phillips Curve (LRPC) is vertical. It implies that the unemployment rate and inflation rate are unrelated in the long run. Suppose the government adopts expansionary monetary or fiscal policies to boost economic growth.In that case, it will cause the aggregate demand curve to shift upward along the long-run aggregate supply curve, leading to a rise in the price level, but the output level remains fixed at the potential level.

Therefore, the price level rises, but the unemployment level does not increase. So the vertical LRPC suggests that the government policies would not be able to reduce the unemployment rate. However, there will be a rise in the inflation rate.