Question

Let the US economy be characterized by low aggregate output and low and stable inflation. Then, provide a clear definition of the Phillips Curve and consider whether this initial state is consistent with what is shown by this empirical relationship. Conclude by discussing under what conditions expansionary fiscal and monetary could lead to demand-pull inflation. How is economic growth impacted?

Answer 1

Phillip’s Curve & Economic Growth

Phillip’s curve shows the stable and inverse relationship between inflation and unemployment. The US economy characterized by low aggregate output, low and stable inflation is the evidence of low growth of economy and reduction in unemployment. As the Phillip’s curve says, unemployment is reduced by raise in inflation which occurred after the increase in demand and supply for goods and services in the economy. The aggregate level of output is increased only through an effect of inflation. An increased supply of money in the economy can increase the demand for commodities thus increasing its price and supply. The increased need of production will reduce the level of unemployment and thus further increasing the level of demand and supply. The direct relationship between inflation and output growth explains how an economic growth if tied up with inflation as Phillip’s curve suggests.

Monetary policies which expand the level of available money supply can stimulate the demand for goods and services which further encourage employment opportunities and growth of economy. Reduced rate of interests to increase the supply of money makes it easy to avail loans for firms and companies to expand their investments. The monetary policies can overall affect the increase in demand and supply for final and intermediary goods which helps the economy to grow further.

Fiscal policies also have importance to stimulate the growth of economy through encouraging demand and supply. Relaxations in corporate, sales and income taxes could increase the level of supply through increased demand from increased level of disposable income. Reduction in taxes and various subsidies can increase the level of disposable income for consumption. Along with the effect of monetary policies, production incentives for firms, increased ability to purchase by the consumers through transfer payments and tax exceptions could all encourage demand which further encourages production and growth of the economy.