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Chapter 35: Problem 2

Illustrate the effects of the following developments on both the short-run and long-run Phillips curves. Give the economic reasoning underlying your answers. a. a rise in the natural rate of unemployment b. a decline in the price of imported oil c. a rise in government spending d. a decline in expected inflation

Short Answer

Expert verified
a) Both curves shift right. b) Short-run shifts left; long-run unchanged. c) Short-run moves left; long-run unchanged. d) Short-run shifts left; long-run unchanged.

Step by step solution

01

Understanding the Short-Run Phillips Curve

The short-run Phillips curve represents the inverse relationship between inflation and unemployment, suggesting that with lower unemployment, inflation tends to be higher, and vice versa. It can shift due to changes in expectations or supply shocks.
02

Understanding the Long-Run Phillips Curve

The long-run Phillips curve, in contrast, is vertical at the natural rate of unemployment. It indicates that there's no trade-off between inflation and unemployment in the long run, and economy always returns to the natural rate of unemployment regardless of the inflation rate.
03

Analyzing a Rise in the Natural Rate of Unemployment

An increase in the natural rate leads to a rightward shift of the long-run Phillips curve, indicating a higher baseline unemployment level. The short-run Phillips curve also shifts rightward since both the long-run and short-run natural rates coincide.
04

Effects of a Decline in the Price of Imported Oil

A decrease in oil prices, a favorable supply shock, shifts the short-run Phillips curve to the left, lowering inflation for the same unemployment rate. The long-run Phillips curve remains unaffected as oil prices don't change the natural rate of unemployment.
05

Impact of a Rise in Government Spending

Increased government spending can boost demand, potentially leading to a leftward movement along the short-run Phillips curve, indicating lower unemployment with higher inflation. In the long run, as the economy adjusts, the Phillips curve returns to its original position, aligning with the unchanged natural rate of unemployment.
06

Consequences of a Decline in Expected Inflation

Lower expected inflation causes the short-run Phillips curve to shift left as people expect lower inflation, which lowers inflation at any unemployment level. The long-run Phillips curve remains unchanged because expectations don't alter the natural rate.

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Key Concepts

These are the key concepts you need to understand to accurately answer the question.

Natural Rate of Unemployment
The natural rate of unemployment is a fundamental aspect of an economy, representing the level of unemployment that exists even when the economy is performing well. This rate consists of frictional unemployment (people temporarily between jobs) and structural unemployment (mismatch between skills and jobs). It is important to note that the natural rate does not involve cyclical unemployment, which results from economic downturns.
  • The natural rate is often considered unavoidable and influenced by factors such as technology and education changes.
  • When this rate increases, it shifts the long-run Phillips curve to the right, indicating a baseline higher unemployment level.
In essence, policies aiming merely to reduce the natural unemployment rate might face difficulties without substantial improvements in the economy's supply side.
Short-Run Phillips Curve
The short-run Phillips curve portrays the trade-off between inflation and unemployment, suggesting that lower unemployment can coincide with higher inflation. However, this relationship is not stable and can shift.
  • In the short term, inflation and unemployment have an inverse relationship.
  • Shifts in the curve can occur due to changes in expectations, supply shocks, or policy decisions.
When an event like a government spending increase occurs, it may cause movement along the curve, typically leading to lower unemployment but higher inflation temporarily. However, if expectations or external shocks change, the entire curve may shift either left or right.
Long-Run Phillips Curve
In the long run, the Phillips curve is not a trade-off. It is depicted as a vertical line at the natural rate of unemployment. This is because, over time, any attempt to keep unemployment below its natural rate will only increase inflation without affecting unemployment.
  • The economy always returns to its natural rate of unemployment in the long run.
  • Long-term policies that aim to exploit the inflation-unemployment trade-off may fail, increasing inflation without reducing unemployment.
Thus, the vertical long-run Phillips curve highlights the idea that sustainable economic policy needs to focus on shifting this natural rate through structural causes like technology, education, or market reforms rather than purely monetary measures.
Expected Inflation
Expected inflation plays a critical role in determining how the Phillips curve shifts. If economic agents expect higher inflation in the future, they adjust their behavior accordingly.
  • When expected inflation rises, the short-run Phillips curve shifts to the right as workers demand higher wages, and firms increase prices ahead of anticipated cost increases.
  • Conversely, if expected inflation declines, the curve shifts left, leading to lower inflation pressures at any unemployment level.
Expectations about future inflation can influence current inflation and unemployment outcomes, often making accurate forecasts and transparent communication important tools for policymakers.
Government Spending
An increase in government spending is a common fiscal policy tool aimed at stimulating economic activity. It works by boosting aggregate demand, which can temporarily reduce unemployment.
  • In the short run, more government spending shifts aggregate demand to the right, potentially moving the economy along the Phillips curve to lower unemployment but higher inflation levels.
  • Long-term effects may be neutral if increased spending results merely in higher inflation without affecting the natural rate of unemployment.
While beneficial in the short run, excessive reliance on government spending for long-term growth can lead to inflationary pressures without addressing fundamental supply-side issues in the economy.
Imported Oil Prices
Changes in imported oil prices significantly impact inflation and indirectly unemployment, given oil's central role in the global economy.
  • A decrease in oil prices, considered a positive supply shock, reduces production costs, shifting the short-run Phillips curve to the left, which results in lower inflation at the same unemployment rate.
  • Alternatively, rising oil prices push the curve to the right, leading to higher inflation for any level of unemployment.
These shifts highlight the sensitivity of inflationary pressures to changes in commodity prices, emphasizing the need for policymakers to account for such external factors when shaping economic strategies.
Inflation-Unemployment Trade-off
The inflation-unemployment trade-off is a concept central to the Phillips curve, particularly in the short run. It suggests that low unemployment can only be achieved at the cost of higher inflation and vice versa.
  • In the short run, economic policy can exploit this trade-off to reduce unemployment, but it often leads to rising inflation rates.
  • However, in the long run, this trade-off vanishes as expectations adjust and the economy returns to the natural rate of unemployment, depicted by the vertical long-run Phillips curve.
Understanding this trade-off is crucial for policymakers who need to balance objectives of low inflation and low unemployment without generating unstable economic conditions.

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Most popular questions from this chapter

Suppose that a fall in consumer spending causes a recession. a. Illustrate the immediate change in the economy using both an aggregate- supply/aggregate-demand diagram and a Phillips-curve diagram.On both graphs, label the initial long-run equilibrium as point A and the resulting short-run equilibrium as point B. What happens to inflation and unemployment in the short-run? b. Now suppose that over time expected inflation changes in the same direction that actual inflation changes. What happens to the position of the short-run Phillips curve? After the recession is over, does the economy face a better or worse set of inflation\(-\)unemployment combinations? Explain.

Suppose the natural rate of unemployment is 6 percent. On one graph, draw two Phillips curves that describe the four situations listed here. Label the point that shows the position of the economy in each case. a. Actual inflation is 5 percent, and expected inflation is 3 percent. b. Actual inflation is 3 percent, and expected inflation is 5 percent. c. Actual inflation is 5 percent, and expected inflation is 5 percent. d. Actual inflation is 3 percent, and expected inflation is 3 percent.

Suppose the Federal Reserve's policy is to maintain low and stable inflation by keeping unemployment at its natural rate. However,the Fed believes that the natural rate of unemployment is 4 percent when the actual natural rate is 5 percent. If the Fed based its policy decisions on its belief,what would happen to the economy? How might the Fed come to realize that its belief about the natural rate was mistaken?

The inflation rate is 10 percent, and the central bank is considering slowing the rate of money growth to reduce inflation to 5 percent. Economist Milton believes that expectations of inflation change quickly in response to new policies,whereas economist James believes that expectations are very sluggish. Which economist is more likely to favor the proposed change in monetary policy? Why?

Suppose the Federal Reserve announced that it would pursue contractionary monetary policy to reduce the inflation rate. Would the following conditions make the ensuing recession more or less severe? Explain. a. Wage contracts have short durations. b. There is little confidence in the Fed's determination to reduce inflation. c. Expectations of inflation adjust quickly to actual inflation.
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