Question

Suppose the economy today is producing output at its potential level and the inflation rate is...

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?

Homework Answers

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.

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