Question

5. An oil shock: Consider an economy that begins with output at its potential level and a relatively high inflation rate of 6%, reflecting some recent oil price shocks. As the head of the Federal Reserve, your job is to pick a sequence of short-run output levels that will get the rate of inflation back down to 3% no later than 3 years from now. Your expert staff offers you the following menu of policy choices: -Short-run output- -Inflation- Option Year 1 Year 2 Year 3 Year 1 Year 2 Year 3 3% -4% -2% 0 4% 3% -2% - 2% -29 5% 49 396 -6% 0 39% 3% (a) According to these numbers, what is the slope of the Phillips curve? (b) If you as a policymaker cared primarily about output and not much about the inflation rate, which option would you recommend? Why?

(c) If you cared primarily about inflation and not much about output, which option would you recommend? Why?
(d) Explain the general trade-off that policymakers are faced with according to the Phillips curve.

Answer 1

answer:

(a) calculating change in inflation in 3 3years,

we get

option	year1	year2	year3
1	3-6= -6	3-3= 0	3-3= 0
2	4-6= -2	3-4= -1	3-3= 0
3	5-6= -1	4-5= -1	3-4= -1

now, slope of philips curve=$\frac{change \ in \ inflation}{short \ run \ outpout}$

$option \ 1 : \ \ slope \ = \frac{-3}{-6}$

$option \ 2 : \ \ slope \ = \frac{-2}{-4}$

$option \ 3 : \ \ slope \ = \frac{0}{0}$

(there is no curve in the option since all the points coincide)

(b) If the only concern is output and not inflation rate, Option 1 seems to be the best one. Because in option 1, Short run output is lowest for Year1, but stabilizes Year2 onwards. Thus a cumulative output over three year period, will be better than option2, or Option3.

(c) Going by the same reason as (b) above, If inflation is the concern and not the output, Option 1 is still the best option since change in inflation is steeper in this option. In Year1 itself change is -3% and from Year2 onwards, it is 0%, hence inflation is best controlled using option 1.

(d) General tradeoff according to phillips curve is that change in inflation and short run output are directly proportional. Thus while controlling inflation is desirable, increase inflation acts as a result of this, which is not desirable. Hence it needs to be seen which option is the best suited, and weather the projected levels of inflation are acceptable to achieve the projected levels of growth