Assume that an economy's long-run equilibrium is described as follows: economic growth at 2.5% pa, the...

Assume that an economy's long-run equilibrium is described as follows:
economic growth at 2.5% pa, the natural rate of unemployment at 6% and expected inflation at 2%.
Using large AD/AS and Phillips curve diagrams, illustrate the short-run effects of the given policy or event on the economy (Assume the price level is not sticky):

Starting Position: Recession, below natural rate.
Policy/event: No policy respose.

Expert Solution

The curve from Phillips shows the correlation between inflation and short-term unemployment. The relationship between unemployment and inflation is inverse. Higher inflation leads to lower unemployment and lower inflation leads to decreased unemployment. This is because the amount of aggregate supply varies according to price levels and the price change depends on aggregate demand. Increasing aggregate demand results in increased costs, increased production, lower unemployment and vice-versa.

The monetary authority's rise in interest rate decreases consumer spending and business spending as borrowing rates increase with a higher interest rate. The change to the left in aggregate demand leads to lower costs, reduced production and increased unemployment. A left change in the aggregate demand curve results in a downward trend in the Phillips curve that indicates a decline in the rate of inflation and increased unemployment. Whether inflation of aggregate demand and unemployment influences an increase in interest rate can be explained with the AD-AS model and Phillips curve.

The rising interest rate is reducing aggregate demand. The aggregate curve of demand moves from AD to ADI to the left, the price level decreases to PL1. Diminishes GDP to YI. The fall in inflation below 2 per cent and the fall in production to Y1 lift the rate of unemployment above the natural rate in shortrun from 6 per cent to 8 per cent. The economy shifts down from point A to B on the Phillips curve.

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Rahul Sunny answered 6 months ago

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