Question

10. The natural unemployment rate in the United States has varied over the last 50 years. According to the Congressional Budget Office, the natural rate was 5.5% in 1960, rose to about 6.5% in the 1970s, and had declined to about 4.8% by 2000. What do you think might have caused this variation?

11. Suppose the Fed begins carrying out an expansionary monetary policy in order to close a recessionary gap. Relate what happens during the next two phases of the inflation-unemployment cycle to the maxim “You can fool some of the people some of the time, but you can’t fool all of the people all of the time.”

Answer 1

The natural rate of unemployment is the long run rate of unemployment which will increase due to higher expected inflation. This is because higher expected inflation translates into higher wages which causes higher unemployment in the long run. The rise in natural rate of unemployment in 1970 from 1960 can be attributed to higher expected inflation rates while the decrease in unemployment in 2000 is due to lower expected inflation rates.

When the Fed carries out an expansionary monetary policy, it creates expectations of higher prices in future that increases investment and production in the economy. This may help in closing the recessionary gap for some time. Beyond a point, however, the investors would realize that the monetary policy is not leading to any real increase in demand and is only translating into higher wage payments for workers. Therefore, this inflation unemployment cycle will come to an end as the investors can't be fooled regarding the economy anymore.