Question

1. Is the Phillips curve a myth? Intertemporal tradeoff between inflation and unemployment After the World War II, empirical economists noticed that, in many advanced economies, as unemployment fell, inflation tended to rise, and vice versa. The inverse relationship between unemployment and Inflation, was depicted as the Phillips curve, after William Phillips of the London School of Economics. In the 1950s and 1960s, the Phillips curve convinced many policy makers that they could use the relationship to pick acceptable levels of unemployment and inflation for the economy. They adjusted taxes, public expenditures, and interest rates to choose a desirable spot on the Phillips curve. However, theories based on the Phillips curve failed to explain stagflation of the 1970s, when many countries experienced high levels of both inflation and unemployment. Many economists began questioning the validity of the Phillips curve. Edmund Phelps of Columbia University suggested that the perceived tradeoff between unemployment and inflation was only temporary, and in the long run, the tradeoff disappears. Does this mean that the relationship revealed in the post-World War II data was invalid, and the Philips curve itself is flawed? Read the following article, and then answer the subsequent questions. IS THE PHILLIPS CURVE A MYTHY BY THE APLIA CONTENT TEAM Phelps's research, which was conducted in the 1960s and 1970s and earned him a Nobel Prize in Economics in 2006, suggests that there will always be some frictional unemployment as workers move between jobs because of layoffs and quitting. In a world with no surprises, unemployment should return to a specific rate the natural rate of unemployment-that is determined by turnover in the labor market. An unexpected increase in the rate of inflation might push the unemployment rate below this natural level, but the effect, he reasoned, should be temporary For policy makers, Phelps's insights offered both good news and bad news. The bad news is that any fiscal or monetary program can keep unemployment below the natural rate only so long as it keeps generating a sequence of unexpected increases in the inflation rate. The good news is that since unemployment tends toward its natural rate, regardless of the inflation rate, policy makers can achieve permanently lower inflation without permanently higher unemployment. In a 2008 speech, economist Frederic Mishkin of Columbia University emphasized that the central bank has a dual goal of achieving price stability and maximum sustainable employment. The short-run Philips curve is not a myth. It is not vertical, and it does imply that expansionary monetary policy that raises inflation can lower unemployment. The long-run Phillips curve, however, is vertical because the economy gravitates to a natural rate of unemployment and is independent of the inflation rate. Therefore, in the long run, any central bank's strategy to keep unemployment below the natural rate would only lead to higher inflation, which would lower economic activity in the long run In practice, in the short run, a negative shock to aggregate demand that caused by households cutting spending leads to a decline in actual output

Answer 1

Solution:

a) No lower unemployment, but higher inflation if unemployment falls below the equilibrium level which increases the expectation of a price rise.

b) A contractionary monetary policy put in place to lower inflation due to a negative supply shock can lead to lower output