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%**

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