Question

7. Expectations and the Phillips curve 

The following graph shows an economy in long-run equilibrium at point A (grey star symbol). The vertical line is the long-run Phillips curve. The downward-sloping curve labeled SRPC1 is the short-run Phillips curve passing through point A.

The expected inflation rate along \(\mathrm{SRPC}_{1}\) is _______.

Suppose that the Federal Reserve (the Fed) suddenly and unexpectedly increases the money supply in an effort to reduce unemployment. As a result of this unanticipated action, actual inflation rises to \(5 \% .\) On the previous graph, use the black point (X symbol labeled "B") to illustrate the short-run effects of this policy.

Now, suppose that-after a period of \(5 \%\) inflation-households and firms begin to expect that the inflation rate will continue to be \(5 \%\). On the previous graph, use the red line (cross symbols) to draw \(\mathrm{SRPC}_{2}\), the short-run Phillips curve that is consistent with these expectations, assuming that it is parallel to \(\mathrm{SRPC}_{1}\).

Finally, using the orange point (square symbol labeled " \(\mathrm{C}^{\text {" }}\) ), indicate on the previous graph the new long-run equilibrium for this economy. The inflation rate at point \(C\) is \(\quad\) the inflation rate at point \(A\), and the unemployment rate at point C is \(\quad\) the unemployment rate at point A.

Was the Fed able to achieve its goal of lowering unemployment?

• Yes, the Fed's policy successfully reduced unemployment in both the short run and the long run.

• No, because the Fed cannot affect the unemployment rate through monetary policy.

• Yes, but only in the short run; in the long run, unemployment returned to its natural rate.

Now, suppose that the public fully anticipates the Fed's decision to increase the money supply. Assume the public also believes that the Fed is firmly committed to carrying out this policy. According to rational expectations theory, when the economy is in long-run equilibrium, a fully anticipated increase in the money supply will cause the economy to move \(\quad\) on the previous Phillips curve diagram. In this case, rational expectations theory predicts that the fully anticipated increase in the money supply will have the immediate effect of \(\quad\) in the inflation rate and \(\quad\) in the unemployment rate.

Answer 1

Part 1) expected inflation is 3%

SRPC cuts the LRPC at the expected inflation rate.

part 2)

Now U falls & we move along the SRPC1 upwards, so inflation is 5% at point B.

Now when expected inflation rises to 5%, then SRPC shifts upwards to SRPC2, where it cuts the LRPC at 5%

& So point c , where π = 5%, shows new long run equilibrium..

Now at point c, inflation is​​​ higher than at A &

unemployment rate is same as at A.

MCQ:

option C) bcoz only in short run, u falls.

as in long run, inflationary expectations revise upwards & unemployment returns to its natural level.

Fully anticipated monetary policy has no real impact on economy, no effect on GDP , only price rise happens

rational expectations theory says that immediate increase in inflation & no change in unemployment rate.