Question

• If the economy is at the natural rate of unemployment with the level of real GDP at potential output, what would expansionary fiscal or monetary policy do to the economy?   How would the economy be effected in the short run and long run? Does the Phillips Curve theory explain what happens?

Answer 1

When the economy is at potential output level, and expansionary fiscal or monetary policy is implemented, then demand pull inflation takes place in the economy. It cause, increase in AD in the short run and AD curve shifts to the right. It creates expansionary gap in the economy. Here, price level also increases. Unemployment rate also goes below the level of the natural rate of unemployment.

But, it increases the cost of production and AS curve shift to the left in the long run. As a result, economy goes back to the potential output level in the long run. Though, price level further increases and reaches to the new high. The unemployment rate also reaches to the level of the natural rate of unemployment.

Phillips curve can also explain it.  With expansionary policy, there will be short run upward increase in price to the SR Phillips curve. The movement will be along the SR Phillips curve. It increases the inflation and decreases the unemployment rate. But, in the long run, there will be a left ward shift in LR Phillips curve to achieve natural rate of unemployment even if the price level increases.