Question

• Suppose the short run Phillips Curve is given by:

Inflation = Expected Inflation +.2 -4*Unemployment Rate

       Assume that initially, people expect zero inflation.

• Draw the short run Phillips Curve and the long run Phillips Curve on a graph
• On the graph, represent what would happen in the short run if the government decided to run 4% inflation (setting inflation =0.04).
• On the graph, represent what would happen in the long run if the government decided to run 4% inflation.

Answer 1

SRPC :

π= πe + .2 - 4*U

a) πe = 0

Then SRPC : π= .2- 4*u

At natural rate of Unemployment

π= πe, so, .2= 4u

un = .2/4= .05= 5%

so, LRPC is Vertical at 5%

B) if govt runs π= .04

Then .04= .2 - 4*u

4u = .2-.04= .16

U*= .16/4= .04 = 4%

Thus Unemployment rate falls below natural rate by 1%>

.

c) in long run,

SRPC will shift upwards in a way , that SRPC cuts LRPC at 4% inflation rate, thus in long run economy will be at LRPC where unemployment rate is back to its natural level of 5% with permanently higher inflation of 4%