Explain why a decrease in aggregate demand causes a movement along the short-run Phillips curve.
A decrease in aggregate demand leads to a new short-run equilibrium at a lower level of output and a lower price level. It takes fewer workers to produce less output, so the unemployment rate increases. And the lower price level corresponds with a decrease in inflation (or with deflation). So, with a higher unemployment rate and a lower inflation rate, there is a movement downward and to the right along the short-run Phillips curve.
Question
Why is there no long-run trade-off between unemployment and inflation?
There is no long-run trade-off between unemployment and inflation because, after expectations of inflation change, wages will adjust to the change, returning the employment and unemployment rates to their equilibrium (natural) levels. This implies that once expectations of inflation fully adjust to any change in actual inflation, the unemployment rate will return to the natural rate of unemployment, or NAIRU. This also implies that the long-run Phillips curve is vertical.
Question
Why is disinflation so costly for an economy? Are there ways to reduce these costs?
Disinflation is costly because, in order to reduce the inflation rate, aggregate output in the short run must typically fall below potential output. This, in turn, results in an increase in the unemployment rate above the natural rate. In general, we would observe a reduction in real GDP. The costs of disinflation can be reduced by not allowing inflation to increase in the first place. The costs of any disinflation will also be lower if the central bank is credible and it announces its policy to reduce inflation in advance. In this situation, the adjustment to the disinflationary policy will be more rapid, resulting in a smaller loss of aggregate output.
Question
Why won’t anyone lend money at a negative nominal rate of interest? How can this pose problems for monetary policy?
If the nominal interest rate is negative, an individual is better off simply holding cash, which has a 0% nominal rate of return. If the options facing an individual are to lend and receive a negative nominal interest rate or to hold cash and receive a 0% nominal rate of return, the individual will hold cash. Such a scenario creates the possibility of a liquidity trap, in which monetary policy is ineffective because the nominal interest rate cannot fall below zero. Once the nominal interest rate falls to zero, further increases in the money supply will lead firms and individuals to simply hold the additional cash.