Assume that the Phillips curve for a given economy is given by: π = πt-1 – 0.5 (ut – 0.06)
1. Explain the concept of the natural level of unemployment using the above Phillips curve.
2. draw the short-run and the long-run Phillips curve.
3. Suppose that the Central Bank wants to reduce the inflation rate in period t by 5%. According to the Phillips curve defined above explain the effects of this policy in the short-run.
4. By considering the Okun’s law, what is the change in GDP that will be associated with the change in unemployment rate.
1. The natural level of unemployment is the rate of unemployment that exists when the economy is in equilibrium, with no cyclical fluctuations in output or prices. In the above Phillips curve, it can be found by setting ut (the unemployment rate) equal to its natural rate, which is assumed to be constant over time. When this is done, the equation becomes: π = πt-1 – 0.03, meaning that inflation depends only on its past value, not on the level of unemployment.
2. The short-run Phillips curve shows the negative relationship between the inflation rate and the current unemployment rate. It is downward sloping, reflecting the fact that as unemployment decreases, firms must pay higher wages to attract workers, and these higher costs are passed on to consumers as higher prices. The long-run Phillips curve, on the other hand, is a vertical line at the natural rate of unemployment. This reflects the fact that in the long run, there is no tradeoff between inflation and unemployment, and the economy will converge to the natural rate regardless of the level of inflation.
3. If the central bank wants to reduce inflation by 5%, it will need to reduce the level of output below its natural level in order to put downward pressure on prices. One way to do this is to increase interest rates, which will make borrowing more expensive and reduce spending throughout the economy. This will lead to a temporary increase in unemployment and a shift in the short-run Phillips curve to the left, as shown in the diagram below. As the economy adjusts, the unemployment rate will eventually return to its natural rate, but at a lower level of inflation.
4. Okun's law states that there is a negative relationship between the unemployment rate and the level of GDP, with each percentage point increase in unemployment associated with a decrease in GDP of about 2%. Therefore, if the central bank reduces the inflation rate by 5%, and this leads to a temporary increase in unemployment of 1%, we would expect to see a corresponding decrease in GDP of about 2%. However, this relationship may not hold precisely in all cases, as other factors can also influence the relationship between unemployment and output.
1. The natural level of unemployment refers to the level of unemployment that exists in an economy when it is operating at its potential or full employment level. It is often referred to as the non-accelerating inflation rate of unemployment (NAIRU). In the given Phillips curve, the natural level of unemployment can be inferred from the equation. When there is no deviation from the previous inflation rate (πt-1) and the expected unemployment rate (0.06), the inflation rate (π) will be equal to the previous period's inflation rate. This implies that when the economy is at its natural level of unemployment, there is no trade-off between inflation and unemployment.
2. The short-run Phillips curve (SRPC) shows the relationship between inflation and unemployment in the short run, while the long-run Phillips curve (LRPC) represents the relationship in the long run. In the short run, the SRPC is upward sloping, indicating that there is a trade-off between inflation and unemployment. Higher inflation is associated with lower unemployment and vice versa. In the long run, however, the LRPC becomes a vertical line at the natural level of unemployment, showing that there is no long-run trade-off between inflation and unemployment. The LRPC is determined by factors such as productivity, population growth, and labor market efficiency.
3. If the Central Bank wants to reduce the inflation rate in period t by 5%, according to the Phillips curve equation, the equation can be rewritten as follows: 0.05 = πt-1 - 0.5 (ut - 0.06). By rearranging the equation, we can solve for ut: ut = (πt-1 - 0.05 + 0.03)/0.5. In the short-run, this policy would lead to a decrease in the inflation rate compared to the previous period, assuming the previous inflation rate is higher than the target. This would likely result in a decrease in the unemployment rate as well, as there is a negative relationship between unemployment and inflation in the short run.
4. Okun's law describes the inverse relationship between the change in the unemployment rate and the change in GDP. It suggests that for every 1 percentage point increase in the unemployment rate, there is a corresponding decrease in GDP growth by approximately 2 percentage points. Therefore, to estimate the change in GDP associated with the change in the unemployment rate, you can use the formula: Change in GDP = -2 * Change in unemployment rate.