Question

Suppose the Federal Reserve increases the real interest rate from 2% to 3% (by raising the nominal interest rate), which leads to a decrease in short-run output by 2 percentage points. Now, assume that there are no other shocks to the economy, inflation expectations are adaptive, and inflation drops from 2% to 1.5%, What is the value of the parameter b bar?

Answer 1

The Okun's law states that for each percentage point increase in unemployment from it's natural rate decreases output by 2 percentage points. Therefore, for 2% decrease in output the unemployment has risen over natural rate by 1%. Here the assumption is that initially the economy was in the long run equilibrium.

Therefore,

The Phillips curve is given as

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An inflation falls from 2%, ​​​​​​