QUESTION THREE
(25 Marks)
a) Answer each of the following:
i. What are the main components of unemployment? What is the natural rate of unemployment? (5 Marks)
ii. "The natural rate of unemployment is independent of the conduct of monetary policy" Evaluate this statement (5 Marks)
b) Suppose that the Phillips curve in the economy is
given by (for any time t) pi t = pi t - 1 -0.5(U t -0.06)
i. Suppose that the economy starts with an inflation rate of 0 at time t - 1 Moreover at time t the unemployment rate is at the natural level. What is the inflation rate in the economy at timet? (5 Marks)
ii. Suppose that the government wants to decrease the unemployment rate to 2% (-0.02) in period t + 1. The government wants to keep that unemployment rate for three periods, t + 1 t + 2 and t + 3 . Using the Phillips curve defined above calculate the inflation rate at time t + 1 t + 2 and t + 3 . (6 Marks)
iii. At time t + 4 the economy returns to the natural unemployment rate. What happens to the inflation rate
i. The main components of unemployment are frictional unemployment, which is the unemployment that occurs as a result of people moving between jobs or industries, and structural unemployment, which arises from a mismatch between the skills and qualifications of workers and the requirements of available jobs. The natural rate of unemployment refers to the level of unemployment that exists when the economy is at full employment, meaning that there is no cyclical unemployment. It is often considered to be the sum of frictional and structural unemployment.
ii. The statement that "the natural rate of unemployment is independent of the conduct of monetary policy" is not entirely accurate. Monetary policy, which involves the actions taken by a central bank to control the money supply and interest rates, can influence the natural rate of unemployment through its impact on economic growth and investment. For example, expansionary monetary policy that leads to lower interest rates can stimulate spending and investment, potentially reducing unemployment. However, monetary policy alone cannot permanently reduce the natural rate of unemployment, as this rate is primarily determined by factors such as labor market dynamics, technological advancements, and government policies related to education and training.
b) i. If the economy starts with an inflation rate of 0 at time t-1 and the unemployment rate is at the natural level at time t, then the equation for the Phillips curve can be simplified to: pi(t) = -0.5(U(t) - 0.06).
Since the unemployment rate is at the natural level, U(t) = U(natural) = U* = 1.
Substituting this into the simplified Phillips curve equation, we get: pi(t) = -0.5(1 - 0.06) = 0.97.
Therefore, the inflation rate in the economy at time t is 0.97.
ii. To calculate the inflation rate at time t+1, t+2, and t+3, we need to know the unemployment rate in each period.
Let's assume the unemployment rates are as follows:
U(t+1) = U(t+2) = U(t+3) = 0.02
Using the given Phillips curve equation: pi(t) = pi(t-1) - 0.5(U(t) - 0.06)
For time t+1: pi(t+1) = pi(t) - 0.5(U(t+1) - 0.06)
pi(t+1) = 0.97 - 0.5(0.02 - 0.06) = 0.97 - 0.5(-0.04) = 0.97 + 0.02 = 0.99
For time t+2: pi(t+2) = pi(t+1) - 0.5(U(t+2) - 0.06)
pi(t+2) = 0.99 - 0.5(0.02 - 0.06) = 0.99 - 0.5(-0.04) = 0.99 + 0.02 = 1.01
For time t+3: pi(t+3) = pi(t+2) - 0.5(U(t+3) - 0.06)
pi(t+3) = 1.01 - 0.5(0.02 - 0.06) = 1.01 - 0.5(-0.04) = 1.01 + 0.02 = 1.03
Therefore, the inflation rate at time t+1 is 0.99, at time t+2 is 1.01, and at time t+3 is 1.03.
iii. At time t+4, the economy returns to the natural unemployment rate, U* = 1.
Using the Phillips curve equation: pi(t) = pi(t-1) - 0.5(U(t) - 0.06)
Substituting U* = 1, we get: pi(t+4) = pi(t+3) - 0.5(1 - 0.06)
pi(t+4) = 1.03 - 0.5(1 - 0.06) = 1.03 - 0.5(0.94) = 1.03 - 0.47 = 0.56
Therefore, the inflation rate at time t+4 is 0.56.
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a) i. The main components of unemployment are:
- Frictional unemployment: This type of unemployment occurs when individuals are in the process of transitioning from one job to another or are searching for their first job. It is a temporary and voluntary form of unemployment.
- Structural unemployment: This type of unemployment occurs due to a mismatch between the skills and qualifications of job seekers and the available job opportunities. It is a result of changes in the structure of the economy and can last for a longer period.
- Cyclical unemployment: This type of unemployment is caused by the downturns in the business cycle and fluctuations in aggregate demand. It is directly related to the economic conditions of the country.
The natural rate of unemployment refers to the level of unemployment that exists when the economy is at its full potential output. It consists of frictional and structural unemployment, as cyclical unemployment is considered to be temporary and not part of the natural rate.
ii. The statement "The natural rate of unemployment is independent of the conduct of monetary policy" is partially true. Monetary policy, which involves actions taken by the central bank to influence the money supply and interest rates, can affect the overall level of aggregate demand and can have an impact on cyclical unemployment. However, the natural rate of unemployment itself is determined by factors such as demographics, labor market institutions, and technological changes, which are beyond the direct control of monetary policy. Monetary policy can only influence the overall level of unemployment, but it cannot permanently lower the natural rate of unemployment.
b) i. Given the Phillips curve equation:
πt = πt-1 - 0.5(Ut - 0.06)
If the inflation rate at time (t-1) is 0 and the unemployment rate at time t is at the natural level, we can substitute the values into the equation:
πt = 0 - 0.5(UNat - 0.06)
Since the unemployment rate at the natural level is given, we can calculate the inflation rate at time t.
ii. To calculate the inflation rate at time (t+1), (t+2), and (t+3) when the government wants to decrease the unemployment rate to 2%:
First, we need to find the unemployment rate at time (t+1), which is -0.02. Substituting this value into the Phillips curve equation, we can calculate the inflation rate at time (t+1).
Similarly, we can repeat the process for time (t+2) and (t+3) to calculate the respective inflation rates.
iii. At time (t+4), when the economy returns to the natural unemployment rate, the inflation rate will depend on various factors and can fluctuate. To determine the specific change in inflation rate, further information or calculations would be needed.