The League of Big States (LBS) has inflation expectations of 5% and an estimate

Question

The League of Big States (LBS) has inflation expectations of 5% and an estimate natural rate of unemployment of 5%. A 2% rise (fall) in unemployment leads to a 1% fall
(increase) in inflation.
(a) What is inflation when unemployment equals 5%?
(b) What is inflation when unemployment falls to 3%?
(c) If unemployment falls to 3% but the Central Bank of LBS thinks that the natural rate has also fallen to 3%, what will happen to inflation?
(d) How will the behavior of interest rates differ in your answers to (b) and (c) if the Central Bank uses higher interest rates to keep inflation at 5%?
(e) The Central Bank is not sure whether or not the natural rate of unemployment has changed. How will its behavior vary depending upon whether its goal is (1) to achieve inflation of 5% or less, (2) try and maintain stable inflation and unemployment, or (3) inflation should be in the range of 4.5–5.5%?
(f) Let inflation expectations be equal to last period’s inflation. Unemployment is currently 5%, the natural rate is 5%, and last year inflation was 5%. The Central Bank wants to lower inflation from 5% to 2%. Compare how unemployment and inflation vary over the next four years when (1) the government wants to achieve 2% inflation next year, (2) the government wants to achieve 2% inflation by lowering inflation by 1% each year.

Explanation / Answer

Answer a : When unemployment is equal to 5%. It means that natural rate of unemployment is exactly equal to unemployment rate. So the inflation remains constant at 5%.

Answer b : The condition is given that 2% fall in unemployment lead to 1% increase in inflation. So, if unemployment falls to 3% than inflation is exactly equal ti 6%.

Answer c : The inflation remains constant at that level because there is NARIU where natural rate of unemployment is equal to actual rate of unemployment in an economy.

Answer d : Higher interest rate is effective in case(b) only as there is inflation rises to 6%. But the higher interest rate is ineffective in the case (c) because here the interest rate has been increased but here the inflation remains constant as the non-accelerating rate of unemployment occurs here only.

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