Chapter 1. Chapter 14 – Problem 3

Step 1

Work It Out

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You must read each slide, and complete any questions on the slide, in sequence.

Question

An economy has the following equation for the Phillips curve:

π = Eπ – .75(u – 5)

People form expectations of inflation by taking a weighted average of the previous two years of inflation:

Eπ = 0.6 π_–1 + 0.4 π_–2

Okun’s law for this economy is:

(Y – Y_–1)/Y_–1 = 2.0 – 2.5 (u – u_–1)

The economy begins at its natural rate of unemployment with a stable inflation rate of 8 percent.

What is the natural rate of unemployment for this economy?

The natural rate of unemployment = DYU2tVvtzEQ=%.

Review Chapter 14 pages 418-421 and 423-425, along with Figure 14-4, for a discussion of the Phillips curve and the short-run tradeoff between inflation and unemployment.

Question

Below is the graph of short-run tradeoff between inflation and unemployment that this economy faces. Give numerical values for the point where the economy begins. This will be point A on the graph.

At point A, the inflation rate = L6bSXEGJIC8=% and the unemployment rate = DYU2tVvtzEQ=%.

Review Chapter 14 pages 418-421 and 423-425, along with Figure 14-4, for a discussion of the Phillips curve and the short-run tradeoff between inflation and unemployment.

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Step 2

Question

An economy has the following equation for the Phillips curve:

π = Eπ – .75(u – 5)

People form expectations of inflation by taking a weighted average of the previous two years of inflation:

Eπ = 0.6 π_–1 + 0.4 π_–2

Okun’s law for this economy is:

(Y – Y_–1)/Y_–1 = 2.0 – 2.5 (u – u_–1)

The economy begins at its natural rate of unemployment with a stable inflation rate of 8 percent.

A fall in aggregate demand leads to a recession, causing the unemployment rate to rise 2 percentage points above its natural rate. On your graph in part (a), label the point the economy experiences that year as point B. (Once again, be sure to give numerical values in the blanks below.)

At point B, the inflation rate = YJYKJgu+ym0=% and the unemployment rate = I0N5oPvoADQ=%.

Review Chapter 14 pages 418-421 and 423-425, along with Figures 14-4 and 14-5, for a discussion of the Phillips curve and the short-run tradeoff between inflation and unemployment. See also the case study entitled, “Inflation and Unemployment in the United States.”

Question

Unemployment remains at this high level for three years (the initial year described in part (c) and two more) after which it returns to its natural rate. Fill out the following table to show unemployment, inflation, expected inflation, and output growth for 10 years beginning two years before the recession. (These calculations are best done on a computer spreadsheet. Please round answers for unemployment and output growth to the nearest whole number. Round answers for inflation and expected inflation to one decimal place.)

Year	Unemployment (u)	Inflation (π)	Expected Inflation (Eπ)	Output Growth [(Y − Y_-1)/Y_-2]
1	cHrGxRpbsMZfBCONMvN2j1m5rK0=	fYKKwtD6tV9y7HP8Ihl7grBTBrNh+4/C	fYKKwtD6tV9y7HP8Ihl7grBTBrNh+4/C	gJSHe/jLBrUfyYvtopQJn8SGbZE=
2	cHrGxRpbsMZfBCONMvN2j1m5rK0=	fYKKwtD6tV9y7HP8Ihl7grBTBrNh+4/C	fYKKwtD6tV9y7HP8Ihl7grBTBrNh+4/C	gJSHe/jLBrUfyYvtopQJn8SGbZE=
3	AK7+VsuvwSTzoqTum6BxR4Y9CYs=	r0JK4kKRQ7XVpwJxUTGAVHsPhVhpKXTg	fYKKwtD6tV9y7HP8Ihl7grBTBrNh+4/C	p8M42qbAqn/tr/+vazILBtiDThs6fV6c
4	AK7+VsuvwSTzoqTum6BxR4Y9CYs=	vbpgKpL9ZNzZ1opOM63EK79b2SilZeig	AjGdHbByV4Z93zLWjDqqc8wcgt3RLblV	gJSHe/jLBrUfyYvtopQJn8SGbZE=
5	AK7+VsuvwSTzoqTum6BxR4Y9CYs=	5YVJRmYPvFuVuVn6cwapQXmdpL/x5knR	ZR0onfv0Bnfu0KDgEI4nrxiebCNkw6r8	gJSHe/jLBrUfyYvtopQJn8SGbZE=
6	cHrGxRpbsMZfBCONMvN2j1m5rK0=	29gNiul4n8lyaH+M2WRqjTedogMiiYeO	29gNiul4n8lyaH+M2WRqjTedogMiiYeO	AK7+VsuvwSTzoqTum6BxR4Y9CYs=
7	cHrGxRpbsMZfBCONMvN2j1m5rK0=	xHinLLyS4fnysmeGImI1MYV3KsXx/sh3	xHinLLyS4fnysmeGImI1MYV3KsXx/sh3	gJSHe/jLBrUfyYvtopQJn8SGbZE=
8	cHrGxRpbsMZfBCONMvN2j1m5rK0=	0liRMczZHwutk0YAmeToeLm6zsbRaUdb	0liRMczZHwutk0YAmeToeLm6zsbRaUdb	gJSHe/jLBrUfyYvtopQJn8SGbZE=
9	cHrGxRpbsMZfBCONMvN2j1m5rK0=	0liRMczZHwutk0YAmeToeLm6zsbRaUdb	0liRMczZHwutk0YAmeToeLm6zsbRaUdb	gJSHe/jLBrUfyYvtopQJn8SGbZE=
10	cHrGxRpbsMZfBCONMvN2j1m5rK0=	0liRMczZHwutk0YAmeToeLm6zsbRaUdb	0liRMczZHwutk0YAmeToeLm6zsbRaUdb	gJSHe/jLBrUfyYvtopQJn8SGbZE=

Table

Review Chapter 14 pages 406-409 and 412-413, along with Figures 14-4 and 14-5, for a discussion of the Phillips curve and the short-run tradeoff between inflation and unemployment. See also the case study entitled, “Inflation and Unemployment in the United States."

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Step 3

Question

An economy has the following equation for the Phillips curve:

π = Eπ – .75(u – 5)

People form expectations of inflation by taking a weighted average of the previous two years of inflation:

Eπ = 0.6 π_–1 + 0.4 π_–2

Okun’s law for this economy is:

(Y – Y_–1)/Y_–1 = 2.0 – 2.5 (u – u_–1)

The economy begins at its natural rate of unemployment with a stable inflation rate of 8 percent.

The graph below illustrates the short-run tradeoff the economy faces at the end of this 10-year period. Label the point where the economy finds itself as point C. (Again, with numerical values in the blanks below.)

At point C, the inflation rate = 9tFSo8IhGSRN04ag % and the unemployment rate = DYU2tVvtzEQ=%.

Review Chapter 14 pages 423-427, along with Figure 14-5, for a discussion of how expected inflation shifts the short-run Phillips curve and for a discussion of disinflation and the sacrifice ratio. See also the case study entitled, “The Sacrifice Ratio in Practice.”

Question

Comparing the equilibrium before the recession with the new long-run (period ten) equilibrium, how much does inflation change? (Note: Please round your answer to the nearest tenth.) How many percentage points of output are lost during the transition? What is this economy’s sacrifice ratio? (Note: Please round your answer to the nearest tenth.)

Inflation jyMzX+0BxekgcDIJY0TwuuzjqcqCZ4pQ by KilC+r3ZaYg= percentage points.

U1syIiEJmco= percentage points of output are lost during the transition.

The sacrifice ratio equals CZBqaQLCevg=.

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