Question

assume that an economy's long run equilibrium is described as follows: economic growth at 2.5% per annum, natural rate of unemployment at 6% and expected inflation at 2%
Using AD/AS and Phillip's curve diagrams illustrate the short run effects of an increase in interest rates with a starting position during a boom, above the natural rate.

Answer 1

The Phillips curve indicates the correlation between inflation and short-term joblessness. Inverse is the relation between unemployment and inflation. Higher inflation results in lower unemployment, and lower inflation results in lower unemployment. This is because the amount of aggregate supply varies by price level, and the increase in price depends on aggregate demand. Rising aggregate demand leads to increased costs, increased production, reduced unemployment and vice versa.

Rising interest rate by the monetary authority reduces consumer spending and company investment as borrowing costs increase with a higher interest rate. The transition in aggregate demand to the left leads to rising prices, lower production and increased unemployment. A left change in the aggregate demand curve leads to a downward trend in the Phillips curve suggesting a decrease in inflation rates and rising unemployment. The AD-AS model and Phillips curve will explain how inflation of aggregate demand and unemployment causes an interest rate increase.

The rising interest rate is pushing down aggregate demand. The aggregate demand curve is shifting from AD to ADI to the left, the price level is decreasing to PL1. Reduces GDP to YI. The fall in inflation below 2 per cent and the decline in output to Y1 lifts the unemployment rate from 6 per cent to 8 per cent above the natural rate in the shortrun. The economy is going down on the Phillips curve from point A to B.

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