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The Philips Curve

Suppose the economy has been experiencing zero inflation and five percent unemployment for several years. The government decides to lower the unemployment percentage by generating some inflation. You need to do the following:

1. Using the Grapher tool, create a graph showing what the short-run effects would be and what would happen in the long run.

2. Give reasons to explain what the government would have to do to keep the unemployment rate at 3 percent.


Solution Preview

The Phillips Curve (PC) shows a short-term, inverse relationship between inflation and unemployment. While it is probably too simplistic to accurately represent the economy, it is useful for learning purposes. Downward sloping, with inflation on the y axis and unemployment on the x, it implies that low levels of inflation will correspond to high levels of unemployment and vice versa. Thus if unemployment is high, the government can "trade" a higher inflation rate to lower it, using an expansionary monetary or fiscal policy. The Phillips Curve shifts depending on various factors. When the public expects inflation there is a upward shift in the PC. At each level of unemployment, there would be a higher inflation rate as inflation becomes incorporated into contracts, since wages are expected to follow prices.

Also important to the concept of the PC is the natural unemployment rate (Un). This is the amount ...

Solution Summary

Short run effects of increasing inflation to lower the unemployment rate. Application of the Phillips curve to governmental policy.