Question

Consider the Phillips curve π_t = π_t-1 – 0.5(u_t – 0.01).

What is the natural rate of unemployment? Graph the short-run and long-run relationships between inflation and unemployment.

How much unemployment is necessary to reduce inflation by 3%? Compute the sacrifice ratio.

Do flexible exchange rates permit a country to pick its own unemployment-inflation trade-off target?                                                               

Answer 1

The currencies are bought and sold in the foreign exchange market. The equilibrium price of foreign currency is determined through the demand and supply of home currency in the exchange market. The equilibrium price of a currency is called the fundamental value of a currency.

The exchange rate is the price of foreign currency in terms of home currency. There are two exchange rate: fixed and flexible. The fixed exchange rate is determined by the government of the country and the flexible exchange rate is determined by the demand and supply in foreign exchange market.

In case of fixed exchange rate the ability of monetary policy is limited. If the government uses the monetary policy to maintain the fundamental exchange rate at official exchange rate, it cannot use it to stabilize the economy. Thus, flexible exchange rate gives the government to use stabilization policy and let them choose the desired inflation and unemployment rate of the economy.