Exercises: The Phillips Curve

Define the short-run Phillips curve (SRPC) and the long-run Phillips curve (LRPC). Say where the LRPC is located and what it shows about the long-run tradeoff.

The natural rate of unemployment is 5%. Along a given SRPC, the unemployment rate falls from 6% to 4%. What happens to the inflation rate, and what type of movement is this (a movement along the curve or a shift of the curve)?

Decide whether each event is a movement along the SRPC or a shift of the SRPC. (a) Expected inflation rises. (b) A negative supply shock raises input costs. (c) An increase in aggregate demand pushes unemployment below the natural rate.

An SRPC contains these points.

The natural rate of unemployment is 5%. (a) At which point is the economy at the natural rate? (b) Describe what is likely true about real GDP relative to potential at point C. (c) Explain what happens to the SRPC and to unemployment in the long run if the economy remains at point C and workers begin to expect higher inflation.

For each shock, describe the effect on the price level and real GDP in the AD-AS model, and the corresponding effect on the Phillips curve diagram (a movement along or a shift of the SRPC). (a) An increase in aggregate demand. (b) A decrease in SRAS from higher oil prices.

The natural rate of unemployment is 5%, and expected inflation is 2%. The economy is at an unemployment rate of 4% and an inflation rate of 4%. (a) Is the economy above or below the LRPC, and is there a recessionary or inflationary gap? (b) Explain what happens to expected inflation, to the SRPC, and to unemployment in the long run. (c) What is the long-run inflation rate if expectations fully adjust to 4%?

In the 1970s, rising oil prices pushed the economy from an unemployment rate of 5% and inflation of 2% to an unemployment rate of 7% and inflation of 6%. (a) Explain this episode using the AD-AS model and the Phillips curve. (b) Explain why policymakers face a dilemma, describing what expansionary and contractionary policy would each do to unemployment and inflation in the short run. (c) Explain what the long-run Phillips curve implies about relying on expansionary policy alone.

The natural rate of unemployment is 5%, and expected and actual inflation are both 6%. The Fed wants to reduce inflation to 2% through contractionary monetary policy. (a) Using the SRPC and LRPC, explain the short-run cost in terms of unemployment as the economy moves along the SRPC. (b) Explain how expectations and the SRPC change over time as inflation falls. (c) Explain why a credible announcement of the policy could reduce the unemployment cost. (d) State the final long-run unemployment rate and inflation rate.