Question

Assume that the economy is at a long-run equilibrium, with unemployment at 5%, and inflation at 2% pa. Suppose a shock causes a very large increase in the cost of crude oil and gas. Assume that Ireland does not produce any oil or gas, and imports large amounts of oil and gas. The shock causes unemployment to rise to 9%, and inflation to rise to 4% pa. Using the data, write out the equation of the Phillips curve before, during, and after the shock. [assume that the oil cost shock causes v = 4%, that the price level is not sticky, and that β = 0.5 in the Phillips curve equation] Your answer should be four lines: an augmented Phillips Curve equation without numbers, then the same equation with the relevant numbers for the three periods.

Answer 1

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Phillips curve equation is

πt = πe - B (U-Un)+V

where

πt= actual inflation rate in t period

πe= expected inflation rate or t-1 period inflation rate

B= okun's coefficient

U = actual unemployment rate

Un =natural unemployment rate

V= supply shock

so before the supply shock

πe= 2

B= 0.5

Un =5

so

πt = 2 - 0.5 (U-5)

πt = 2 - 0.5U+2.5

πt = 4.5- 0.5U before shock phillips curve

During shock

πt+1 =actual inflation rate in t+1 period

πe(expected inflation rate or t period inflation rate) =2

B( okun's coefficient) =0.5

U = actual unemployment rate

Un (natural unemployment rate) =5

V( supply shock) =4

πt+1 = 2 - 0.5 (U-5)+4

πt+1 = 2 -0.5U+2.5+4

πt+1 = 8.5-0.5U during shock phillips curve

if U=9%

then

πt+1 = 8.5-0.5(9)

πt+1 = 8.5-4.5

πt+1 = 4%

After shock

πt+2 (actual inflation rate in after shock period)

πe (expected inflation rate or t+1 period inflation rate )= 4

B( okun's coefficient)=0.5

Un (natural unemployment rate)=5

V(supply shock)=0.

πt+2= 4 - 0.5 (U-5)

πt+2= 4 -0.5U+2.5

πt+2= 6.5 - 0.5U After  shock phillips curve