Question

2. Phillips Curve. An economy has the following functions for its short run aggregate supply (SRAS), Okun's Law (OL), and Phillips Curve (PC): SRAS: P = EP + (1/2)(y - 3) OL: (Y-Y) = -4(u-u") PC:T = ET - (1/5)( - 6) The economy begins at its natural rate of output with a stable price level equal to $5. a.) Output is at its natural level when the price level is equal to expectations. Calculate the natural rate of output in this economy. b.) Construct a graph containing an aggregate demand curve, a short-run aggregate supply curve, and a long-run aggregate supply curve. Indicate the values of Y and P at the short-run equilibrium. Be sure to label the x- and y-axes. c.) Unemployment is at its natural rate when inflation is equal to its expectations. Calculate the natural rate of unemployment in this economy. d.) Assume in equilibrium this economy has a stable inflation rate of 20%. Graph the short-run tradeoff between inflation and unemployment that this economy faces

Answer 1

P EP SRAS P = EP LRAS b) SRAS SRAS P1 5 AD AD 3 T c) E - PC At uU ) ER Assumina A - E = 2o LRPC o 20 \SRPC' .SRPC e) P= 7, EP = 5 , t 6 (T- 3) SRAS ২(7- 3) A Y- 3 New equi b njum : £,

okun's Las: (Y- T 3 un = 6 -4 (u - u") Y - 3 -4 (u - 6) . 73 Y : - *(W-6) 6- 5 unemploymmt faus due to wnexpected P. P P- Rate of inflakion: P-1 Tham ER a2 EA- (n-6) :. PC O A o 2 or, o 2 Car -u 6 2. = 5 calculated before This n Samme as ne eqiibrium in PC graph in 2 The with nigher infiation epectation in tne Loma run Short ru phiwips cwwe Shifts to SRPC'. This also increases EP omd SRAS shifts to SRAS'. TWe new eauiibrium ccurs at E, with higher price uwel P, 777 5 .