Question

1.  Are the effects of an increase in aggregate demand in the aggregate demand and aggregate supply model consistent with the Phillips curve? Explain

2. Explain the connection between the vertical long-run aggregate supply curve and the vertical long-run Phillips curve

3. In the long run what primarily determines the natural rate of unemployment? In the long run what primarily determines the inflation rate? How does this relate to the classical dichotomy?

Answer 1

Answer

(1). Consider what happens when aggregate demand harvests. For example, suppose there is an increase in aggregate demand. The aggregate demand and supply mode shows that prices and output will rise. Rising prices mean that there is inflation. Rising output means falling unemployment. Thus, a shift in the aggregate demand arve along the aggregate-supply is corresponding to a movement along the Philips are.

Even though inflation is unpopular, elected leaders do not always support efforts to reduce inflation because of the short-run costs associated with disinflation. In particular, as disinflation occurs, the unemployment rate rises, and when unemployment is high people tend not to vote for incumbent politicians, blaming them for the bad state of the economy. Thus, politicians tend not to support disinflation.

Economists believe that countries with independent central banks can reduce the cost of disinflation because in those countries politicians cannot interfere with central banks' disinflation efforts. People will believe the central bank when it announces a disinflation because they know politicians cannot stop the disinflation. In countries with central banks that are not independent, people know that politicians who are worried they will not be reelected could stop a disinflation. As a result, the credibility of the central bank is lower and the costs of disinflation are higher.

If a drought destroys farm crops and drives up the price of food, the short-run aggregate-supply curve shifts up, as does the short-run Phillips curve because the costs of production have increased. The higher short-run Phillips curve means the inflation rate will be higher.

(2). Long-run aggregate vertical supply curve says that real output of an economy is independent of prices at a particular level of employment. Real GDP does not change if employment level is not changing irrespective of the change in prices. Here, nominal GDP changes as it considers the change in prices.

Long-run vertical Phillips curve says that natural rate of unemployment in an economy will be as per the real output produced by the economy and it will not change due to inflation or change in prices. Here also, the unemployment rate does not depend upon nominal values.

In above mentioned both the concepts, it is clear that real variables are independent of nominal variables and both the curve are using two real variables. First one is real GDP and the second one is employment. It means that both curves depend upon each other and they are the classic example of “classic dichotomy” that says that real variables can be assessed separately from nominal ones.

(3). In the long run, the natural rate of unemployment is primarily determined by labor market factors including government policy concerning minimum wages and unemployment benefits. In the long run, inflation is primarily determined by money supply growth. These determinants are consistent with the classical dichotomy which states that real and nominal variables are determined independently.