Suppose that an economy has the Phillips curve pi = pi_-1 - 0.5 (u - u\" and tha

Question

Suppose that an economy has the Phillips curve pi = pi_-1 - 0.5 (u - u" and that the natural rate of unemployment Is given by an average of the past two years' unemployment: u" = 0.5(u_-1 + u_-2). Why might the natural rate of unemployment depend on recent unemployment (as is assumed in the preceding equation)? Suppose that the Fed follows a policy to permanently reduce the inflation rate by 1 percentage point. What effect will that policy have on the unemployment rate over time? What is the sacrifice ratio in this economy? Explain. What do these equations imply about the short-run and long-run tradeoffs between inflation and unemployment?

Explanation / Answer

answer 1-The natural rate of unemployment might depend on cuurent rate of unemployment because

a)this can be because of frictional unemployment, as workers lose job skills,find harder to get jobs and thus the desire to work in future falls

b) recent unemployment affect structural unemployment. As labour negotiations give a greater voice to insiders than outsiders ,then insiders might push for more wages at the expense of jobs.

answer 3- As unemployment is always higher than at it stated,output is always lower than it would have been. Thus the ratio is infinite.

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