Suppose the natural rate of unemployment is 6 percent. On one graph, draw two Phillips curves that
describe the four situations listed here. Label the point that shows the position of the economy in each case.
a. Actual inflation is 5 percent, and expected inflation is 3 percent.
b. Actual inflation is 3 percent, and expected inflation is 5 percent.
c. Actual inflation is 5 percent, and expected inflation is 5 percent.
d. Actual inflation is 3 percent, and expected inflation is 3 percent.
Illustrate the effects of the following developments on both the short-run and long-run Phillips curves. Give the economic reasoning underlying your answers.
a. a rise in the natural rate of unemployment
b. a decline in the price of imported oil
c. a rise in government spending
d. a decline in expected inflation
Suppose that a fall in consumer spending causes a recession.
a. Illustrate the immediate change in the economy using both an aggregate-supply/aggregate-demand diagram and a Phillips-curve diagram.On both graphs, label the initial long-run equilibrium as point A and the resulting short-run equilibrium as point B. What happens to inflation and unemployment in the short-run?
b. Now suppose that over time expected inflation changes in the same direction that actual inflation changes. What happens to the position of the short-run Phillips curve? After the recession is over, does the economy face a better or worse set of inflation$-$unemployment combinations? Explain.
Suppose the economy is in a long-run equilibrium.
a. Draw the economy's short-run and long-run Phillips curves.
b. Suppose a wave of business pessimism reduces aggregate demand. Show the effect of this shock
on your diagram from part $a$. If the Fed under-takes expansionary monetary policy, can it return the economy to its original inflation rate and original unemployment rate?
c. Now suppose the economy is back in long-run equilibrium and then the price of imported oil rises. Show the effect of this shock with a new diagram like that in part $a$. If the Fed undertakes expansionary monetary policy, can it return the economy to its original inflation rate and original unemployment rate? If the Fed undertakes contractionary monetary policy, can it return the economy to its original inflation rate and original unemployment rate? Explain why this situation differs from that in part $b$.
The inflation rate is 10 percent, and the central bank is considering slowing the rate of money growth
to reduce inflation to 5 percent. Economist Milton believes that expectations of inflation change quickly
in response to new policies,whereas economist James believes that expectations are very sluggish. Which economist is more likely to favor the proposed change in monetary policy? Why?
Suppose the Federal Reserve's policy is to maintain low and stable inflation by keeping unemployment at its natural rate. However,the Fed believes that the natural rate of unemployment is 4 percent when the
actual natural rate is 5 percent. If the Fed based its policy decisions on its belief,what would happen to
the economy? How might the Fed come to realize that its belief about the natural rate was mistaken?
Suppose the Federal Reserve announced that it would pursue contractionary monetary policy to reduce the inflation rate. Would the following conditions make the ensuing recession more or less severe? Explain.
a. Wage contracts have short durations.
b. There is little confidence in the Fed's determination to reduce inflation.
c. Expectations of inflation adjust quickly to actual inflation.
As described in the chapter, the Federal Reserve in 2008 faced a decrease in aggregate demand caused by the housing and financial crises and a decrease in short-run aggregate supply caused by rising commodity prices.
a. Starting from a long-run equilibrium, illustrate the effects of these two changes using both an aggregate-supply/aggregate-demand diagram and a Phillips-curve diagram. On both diagrams, label
the initial long-run equilibrium as point A and the resulting short-run equilibrium as point B. For
each of the following variables, state whether it rises or falls or whether the impact is ambiguous:
output, unemployment, the price level, the inflation rate.
b. Suppose the Fed responds quickly to these shocks and adjusts monetary policy to keep unemployment and output at their natural rates. What action would it take? On the same set of graphs
from part $a$, show the results. Label the new equilibrium as point C.
c. Why might the Fed choose not to pursue the course of action described in part $b$?