Question

Suppose we have an economy which is in a long-run equilibrium.

a) Graph this economy using long-run and short-run Phillips curves

b) Now suppose the aggregate demand decreased as the government spending is reduced. Show what happens to the economy on a Phillips curve graph. Where is the economy’s current position on the graph now? Is it possible to return to the original position (with the initial inflation and unemployment levels) through monetary policy? Explain

c) Now, you should consider an alternative case. Starting from the initial long-run position of the economy, suppose the oil prices increased. Show the new position of the economy on a Philips curve graph. Is it possible to return to the original position this time (with the initial inflation and unemployment levels) through monetary policy? Explain.

Answer 1

Phillips Curve is a curve which shows the relationship between the inflation and unemployment. If shows that in the short run there is a negative relationship between the two, so the short run Phillips curve is downward sloping. But in the long run there is no trade off between the two and hence the long run Phillips curve is a vertical straight line.

(a)

b) A decrease in aggregate demand brings the economy to a lower level of inflation and a higher level of unemployment as shown in the graph. In this case an expansionary monetary policy may increase the aggregate demand and hence there will be a shift in the AD curve rightward and hence original inflation and unemployment may be restored.

c) If oil prices increased there will be increase in the cist of production and hence less production. This will shift the supply curve to AS1 and hence the corresponding level of inflation in the Phillips curve will increase and the level of unemployment will come down to U1.