Question

6. An economy has a Phillips curve takes the form of p = 0.04 - 0.5(u - 0.03) where is the actual inflation rate and u is the unemployment rate.

1. What is the short-run relationship between inflation and unemployment according to the Phillip curve function above?
2. Explain demand pull inflation using the expression of Phillips curve above.
3. Illustrate cost push inflation using the expression of Phillips curve above.

Answer 1

A) short run philips curve , shows inverse relationship between Unemployment & inflation rate

If U rises above natural rate ( .03, 3%), then p falls, so actual inflation rate falls,

If U falls, actual inflation rises

B) demand pull inflation,

When AD rises, then Unemployment falls, so as per short run by inverse relationship between u & π, inflation will rise

Thus demand causes inflation

We move along SRPC curve upwards

C) cost push inflation

Suplly sude inflation, this leads to both inflation & Unemployment , causing stagflation,

Thus as cost of production rises, input cost rises, then AS Aggregate Supply Curve falls, AS shifts upwards to left ,

Then SRPC shifts upwards to right, bcoz expected inflation rises, due to rise in Production costs

In above eqn, πe = .04= 4%

So πe rises, in case of cost push inflation,

So both inflation & Unemployment rises,