Question

Suppose that an economy has the Phillips curve π = π₋₁ − 0.5(u − 0.06). What is the natural rate of unemployment? How much cyclical unemployment is necessary to reduce inflation by 3 percentage points? And, Calculate the sacrifice ratio.

Answer 1

π = π₋₁ − 0.5(u − 0.06)

Natural Rate of Unemployment is that rate at which current inflation = Previous year inflation

π = π₋₁

and u = un = 0.06 = 6%

π - π₋₁ = -0.03

Plugging this in Phillips curve gives:

-0.03 = -0.5(u - 0.06)

-0.03 = -0.5u + 0.03

0.5u = 0.06

u = 0.12

12% of cycilcal unemployment is necessary to reduce inflation by 3%

Sacrifice Ratio = (Excess Point years of Inflation / Decrease in Inflation)

Sacrifice Ratio = 1 / 0.5

Sacrifice Ratio = 2

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