Assume that an economy is governed by the Phillips curve (pi) t = E (pi)t - 0.55

Question

Assume that an economy is governed by the Phillips curve (pi)t = E(pi)t - 0.55(ut 0.065), where 0.065 is the natural rate of unemployment. Further assume that E(pi)t = (pi)t-1: Suppose that, in period zero, (pi)t = 0.03 and E(pi)t = 0.03, that is the economy is experiencing steady inflation of 3 percent.

a) The government decides to impose raised aggregate demand so that unemployment is cut to 0.04. Suppose the government follows this policy for periods 1 through 6. Create a table of (pi)t and E(pi)t for these six periods.

b) Assume that, for periods 7 through 10, the government decides to hold unemployment at 0.07. Create another table of (pi)t and E(pi)t for these four periods. Is there any reason to expect the inaation rate to go back to 0.03?

c) If the government persisted in its behavior under part a, do you think the public would continue for long forming expectations according to E(pi)t = (pi)t-1? Why?

Explanation / Answer

A. through periods 1 to 6 govt maintain unemployment rate of .04.

so the actual and expected inflation for the following periods are ..

this is found by the philips curve equation.

ex. for period 1 Epi(t) = (pi)t-1 = 0.03

ut=0.04

so pi(t) = 0.03- .55(0.04-0.065) = 0.04375

0.07125

  

B. now the unemployment rate is 0.07. using this we create the table for periods 7-10

as i is evident from the chart that the inflation rate is falling year after year, so if everything is the same then the inflation rate may return to 0.03, but this is going to take a long time as the fall in inflation rate is slow. AS is evident from the table.

C. if the government persists in its behaviour for long then peope will change thier expectation relating to natural rate of unemployment ie 0.04 will become the new level of natural rate of unemployment and the rate of inflation would become constant.

year E(pi)t (pi)t 1 0.03 0.04375 2 0.04375 0.0575 3 0.0575 0.07125 4

0.07125

0.085 5 0.085 0.09875 6 0.09875 0.1125

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