Question

1. What is a Phillips Curve? What are its policy implications?

2. What is the Investment element in Aggregate Demand? What role does the interest rate play in determining the level of Investment?

Answer 1

a) Philips curve tells us that there exist a negative relationship between inflation and unemployment rate in short run. As inflation falls, unemployment rises and vice versa. In long run, Philips curve is vertical line which shows us that with the help of government policies, unemployment is fixed at a point and cannot be changes easily while inflation rate changes.

The main implication is that If unemployment is high, means less people are into work which gives producers a bargaining power over wages and they reduce overall wages which in effect reduces the aggregate demand in the economy. Reduction in aggregate demand pushes producers to reduce the prices of the product which takes the inflation down in the economy.

b) According to Keynesian theory, AD = C + I + G + X - M

Investment have a positive relationship with aggregate demand according to the equation given above.

If interest rate is high, it is costly for producers to make new investment as it will cost them more while repaying the principal amount with interest rate. While interest rate falls, it reduces producers burden as they have to pay less amount in return. Thus interest rate and investment have negative relationship with each other.