Question

Suppose the economy has the Phillips curve ?? = ??−1 − 0.5(?? − ?? ? ), where the natural rate of unemployment is given by the average of past two years’ unemployment: ?? ? = 0.5(??−1 + ??−2).

(i) Why might the natural rate of unemployment depend on recent unemployment (as is assumed in the preceding equation)? [5]

(ii) Suppose the Central bank follows a policy to reduce the inflation rate permanently by 1 per centage point. What effect will that policy have on the unemployment over time? [10]

(iii) What is the sacrifice ratio for this economy in practice? [5]

Answer 1

I) it might be due to hysteresis in Unemployment

bcoz recent Unemployment rates affect frictional Unemployment levels in Economy,

As Unemployed workers lose their job skills , & then find difficult to find , or might get unwilling to do a job

Thus natural Unemployment rate will rise,

Bcoz its combination of structural & frictional Unemployment rate .

now with negative employement shocks, with lower number of workers left, who bargain for higher wages, & so future new contracts will be signed at higher wages, thus hysteresis sets in

2) πt - πt-1= -1%

from Phillips curve :