Question

Assume that an economy is governed by the Phillips curve π = πe – 0.5(u – 0.06), where π = (P – P–1)/P–1, πe = (Pe – P–1)/P–1, and 0.06 is the natural rate of unemployment. Further assume 9 πe = π–1. Suppose that, in period zero, π = 0.03 and πe = 0.03—that is, that the economy is experiencing steady inflation at a 3-percent rate.

a. Now assume that the government decides to impose whatever demand is necessary to cut unemployment to 0.04. Suppose the government follows this policy for periods 1 through 5. Create a table of π and πe for these five periods.

b. Assume that, for periods 6 through 10, the government decides to hold unemployment at 0.06. Create another table of π and πe for these five periods. Is there any reason to expect the inflation rate to go back to 0.03?

c. If the government persisted in its behavior under part a, do you think the public would continue for long forming expectations according to πe = π–1? Why?

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