Question

Use the Phillips curve to show the short‐run trade‐off between inflation and unemployment. When i) demand is above its potential and ii) when demand is below its potential.

Answer 1

In ths short run there is a trade off between unemployement and inflation. When inflation increases unemployement decreases and the vise versa, but in the long run as inflation increases the pofits decreases so the companies will employ lesser worker to increase profits thus returning the employement level to natural rate of unemployement which is the potential gdp output level.

i) When demand is above its potential the economy is in the inflationary gap, If you look at the above graph the inflation increases and the unemployement decreases to point B in the above graph.

ii)When demand is below its potential the economy is in the recessionary gap, If you look at the above graph the inflation decreases to deflation and the unemployement increases to point C in the above graph.