Question

Suppose the economy today is producing output at its potential level and the inflation rate is equal to its long-run level, with ¯π = 2%.

(a) Assume that the slope of the Phillips curve is 3. What happens if policymakers try to stimulate the economy to keep output above potential by 5% every year?

(b) Assume that the slope of the Phillips curve is 1. What happens if policymakers try to stimulate the economy to keep output above potential by 5% every year?

(c) How does your answer depend on the slope of the Phillips curve? What does this tell you about the trade-off between inflation and output?

Answer 1

Here, the slope is given to be 3, and policymakers want Y ̃ to be 5%. Plugging this into the inflation equation above, we get

π = 2% + mY ̃
= 2% + 3(5%) = 2%+15%
∴ π = 17%

Thus, pushing the economy to grow by 5% above potential will generate 17% inflation in the economy

b)

π = 2% + mY ̃
= 2% + 1(5%) = 2% + 5%
∴ π = 7%

Thus, pushing the economy to grow by 5% above potential will generate 7% inflation in the economy.

c)

The slope of the Phillips curve affects the degree of the trade-off between growth and inflation. For the same increase in growth, i.e., 5%, a steeper Phillips curve required the economy to suffer 17% inflation, which is very high.