Question

Considering the Philips Curve as ? = 0.02 − 0.6 (?−0.05), and the government announces that it implements an expansionary monetary policy:

• • E1) Describe the Locus Critique. ( 5 points)
• • E2) Considering the Locus Critique, do you think that the above Philips Curve is a good equation to study the relationship between inflation and unemployment? Why? Explain it. ( 5 points)

Answer 1

Given the Phillips curve ? = 0.02 − 0.6 (?−0.05) the Fed announces the expansionary monetary policy.Given that expansionary monetary policy leads to increase in the price level in the economy.

Part A
According to Lucas the wage setters in the economy does not set their wages according to the inflation rate of the previous year when they came to know that Fed is going to implement a policy. This led to the change in the expectations of the wage setters in the economy. Thus they form their expectations according to the recent policy implemented by the Fed. If the fate announces that it will implement expansionary monetary policy then wage setters will set their wages in a way that they can deal with the inflation in the future. Does wages will rise in the economy at a constant unemployment rate which will further leads to inflation in the economy at present stage.
Lucus also suggest that this policy will only work if Fed is credible to the people of its economy that is because of its trust people of the economy will decide their future wages.
Part B
Given the above equation and Lucas critique the Phillips curve is not a good equation to study the relationship between inflation and unemployment. The reason for this is that expectations is one of the major factor that changes the inflation rate of the economy without affecting the unemployment rate in the economy as shown by Lucas critique in the above part. Thus we can say that the the Lucas critique has debunked relationship inflation rate and unemployment.