Question

Intermediate Macroeconomic Qn.1

1. Illustrate the Phillips curve and explain the economic reasoning behind the negative slope of the curve.
2. Using an example, explain the link between monetary and fiscal policy.

Answer 1

A) Philips Curve is a downward sloping curve representing negative relationship between unemployment and inflation. It shows how increase in unemployment reduces inflation and vice versa.

The economic reasoning behind the negative slope of the curve is that unemployment and inflation are inversely related. As unemployment increases, people lose their jobs and incomes, which reduces their purchasing power and thus shifts AD to the left, leading to a fall in prices and thus inflation.

Similarly, as unemployment decreases, consumer purchasing power increases, leading to increase in inflation.

B)

Monetary policy and Fiscal policy are policy tools used to bring market back into equilibrium in case of disequilibrium.

While monetary policy is set by Fed and involves affecting money supply and AD, fiscal policy is set by government to affect aggregate demand. Both these policies eventually affect AD in the economy.

For example: Suppose the economy is in recession.

As a result, government would institute an expansionary fiscal policy (reduce tax or increase government spending). This would increase consumer income in hand and thus shift AD to the right, leading to an increase in GDP, bringing economy out of recession.

Or, the Fed could institute an expansionary fiscal policy (open market purchase of securities or reduce reserve ratio). This would increase money supply in the economy, thereby increasing consumer income in hand and thus shifting AD to the right, bringing economy out of recession.

Thus, both types of policies work to shift AD curve, to bring economy back to equilibrium.