3. Unemployment, the Phillips Curve and Okun’s Law Suppose the government of Exampleland is considering the...

3. Unemployment, the Phillips Curve and Okun’s Law

Suppose the government of Exampleland is considering the introduction of a new trade policy that consists of rescinding existing free-trade agreements and imposing tariffs on imports.

a) If the Phillips Curve equation for this economy is ?_t = ?_t-1 + 0.03 - 0.5u_t before the new government policy, which of the following would be more likely to represent the new Phillips Curve after the policy is introduced, and why?

(i) ?_t = ?_t-1 + 0.02 - 0.5u_t

(ii) ?_t = ?_t-1 + 0.04 - 0.5u_t

This economy currently has an unemployment rate of 10% and is growing at a 2.6% annual rate. A high-ranking official in the treasury department is quoted in the newspaper as saying that next year's forecast GDP growth rate of 4.1% is expected to bring down the unemployment rate to 7% within a year. The same report also quotes an economist saying that the government's predictions are "highly unlikely" because they "fly in the face of decades of macroeconomic research.”

b) Who do you believe, and why?

Solutions

Expert Solution

a) Phillips curve shows the negative relationship between inflation and unemployment. the ?t = ?t-1 + 0.03 - 0.5ut

Introduction of a new trade policy which imposes tariff will increase the price level of the good.

Now we know that increase in price level is nothing but the increase in inflation. So at the same unemployment rate, the new inflation will be higher than the previous level of inflation. So, the new equation of Phillips curve will be ?t = ?t-1 + 0.04 - 0.5ut

b) Current unemployment rate = 10%, Growth of unemployment = (du/u) * 100 % = 2.6%

From Okun's law, we can say that, ?Y/Y = 0.03 - 2?u

Now GDP growth rate is 4.1% i.e., ?Y/Y = 4.1%

Which means, 0.03 - 2?u = 4.1

or, 2?u = 0.03 - 4.1

or, 2?u = - 4.07

or, ?u = - 2.035

Now the current unemployment rate is 10%

If there is a decrease in unemployment rate by 2.035%, then the new unemployment rate is (10 - 2.035) = 7.965

which is higher than 7%.

So, it is not possible to cut down the unemployment rate to 7% within a year.

Rahul Sunny answered 1 year ago

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