Question

a. Write the Phillips curve with unanchored expectations, using unemployment rates rather than output.

b. Explain briefly how a permanent increase in oil prices would affect the natural rate of unemployment You don't need to draw a wage-setting, price-setting diagram, but do identify which variable a change in oil prices would affect and In what direction

c. Graph your Phillips curve from part (a) and illustrate the effect of the change in the natural rate of unemployment from part (b). If the actual uremployment rate does not charge, what happens to the inflation rate over time? Explain.

Answer 1

Phillips curve relates the rate of inflation with the rate of unemployment. The Phillips curve argues that unemployment and inflation are inversely related: as levels of unemployment decrease, inflation increases. The relationship, however, is not linear.Phillips curve relates the rate of inflation with the rate of unemployment. The Phillips curve argues that unemployment and inflation are inversely related: as levels of unemployment decrease, inflation increases. The relationship, however, is not linear.

Theoretical Phillips Curve: The Phillips curve shows the inverse trade-off between inflation and unemployment. As one increases, the other must decrease. In this image, an economy can either experience 3% unemployment at the cost of 6% of inflation, or increase unemployment to 5% to bring down the inflation levels to 2%.

Part b)

The Determinants of Oil Prices

​With oil's stature as a high-demand global commodity comes the possibility that major fluctuations in price can have a significant economic impact. The two primary factors that impact the price of oil are:

1)Supply and Demand

2) Market sentiment

concept of supply and demand is fairly straightforward. As demand increases (or supply decreases) the price should go up. As demand decreases (or supply increases) the price should go down. Sounds simple?

Not quite. The price of oil as we know it is actually set in the oil futures market. An oil futures contract is a binding agreement that gives one the right to purchase oil by the barrel at a predefined price on a predefined date in the future. Under a futures contract, both the buyer and the seller are obligated to fulfill their side of the transaction on the specified date.

Impact of changes in oil price In short, one could safely conclude that higher crude prices will adversely affect the twin deficits—fiscal and current account deficit—of the economy, which will have spillover impact on the monetary policy, and consumption and investment behaviour in the economy. However, before we talk about the impact in numbers, it is important to address one tricky question: “what is driving higher crude prices?"

The question is relevant because the factors leading to change in prices will decide the sustainability of the higher prices.Impact of changes in oil price.

Part B)Unemployment rates increase in the short run when monetary policy is used to reduce inflation. This is the short term trade-off between unemployment and inflation. In 1958, economist A. W. Philips published an article showing that when inflation is high, unemployment is low, and vice versa. This relationship, when graphed, came to be known as the Phillips curve. Most inflation is caused by demand-pull inflation, when aggregate demand grows faster than aggregate supply. Consequently, businesses hire more labor to increase supply, thus, reducing the unemployment rate in the short run.

But when monetary policy is used to reduce inflation, either by contracting the money supply or by raising interest rates, this reduces aggregate demand, while aggregate supply remains the same. When aggregate demand decreases, prices decrease, but unemployment rises, since aggregate supply is also subsequently reduced.

Short-Term Influence of Inflation on

Employment — the Phillips Curve

Although the unemployment rate fluctuates, it trends toward a natural equilibrium known as the natural rate of unemployment, which is the unemployment rate that would prevail when there have not been any recent changes to monetary policy, when economic output is optimal. The natural rate of unemployment includes frictional unemployment, which is the unemployment that results because it takes time to find another job or a new job, and structural unemployment, which results from a mismatch of the skills that the labor force provides and what the job market demands. The other component of unemployment is cyclical unemployment, which is the unemployment that results when there are fewer jobs than members of the labor force.

Although the natural rate of unemployment cannot be lowered by monetary policy over the long-run, cyclical unemployment can be reduced, at least temporarily, through monetary policy.

It was Milton Friedman and Edmund Phelps who showed that the Phillips relationship between unemployment and inflation was valid over the short run but not over the long run. Over the long run, the natural rate of unemployment would be unaffected by prices. This accords with the principle of monetary neutrality, which simply states that nominal quantities, such as prices, cannot affect real variables, such as output and employment. If prices go up, incomes generally follow.

Hence, the long-run Phillips curve is vertical, meaning the unemployment rate does not depend on money growth or inflation in the long-run; instead, it depends on the natural rate of unemployment, which, itself, can change over time due to changes in minimum wage laws, collective bargaining, unemployment insurance, job training programs, and changes in technology.