Question

• Exercise 2 Consider the following Phillips curves for country A and B (assuming that the = 7+-1): - (2) T = 1 + (m4 +24) – aux TB = R1 + (mB + zB) - au (3) where a is the inflation rate, m is the markup, z includes institutional characteristics , Ut is the effective unemployment rate and a is a parameter which describes the magnitude of the impact of unemployment on real wages. 1. Assume that a = 2 and m = 2 in both countries. Moreover, due to the longer duration of unemployment benefits in country B, then 24 = 3 and 2B = 14. Compute the natural rate of unemployment for the two countries and briefly comment. 2. Given the results in point 1), if unemployment rate is 7% in both countries, in which direction will inflation in t go in country A and B? Briefly comment by providing the economic reason behind your results.

Answer 1

1) at natural unemployment rate , πt = π(t-1)

So , (m+z) = a*Un

natural unemployment rate, Un = (m+z)/a

in A) Un = (2+3)/2 = 5/2

Un * = 2.5%

in B) Un = (2+14)/2

= 8%

thus as B has higher unemployment benefits, so B will have higher Natural unemployment rate .

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2) U = 7

In A) πt = π(t-1) + (5-14)

πt = π(t-1) -9

as current unemployment rate is above natural rate of 2.5%, so inflation rate will fall

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In B) πt = π(t-1) + 2

so in B) as current UNEMPLOYMENT rate is below natural rate of 8%,

so as per Phillips curve, inflation rate will increase

.