Question

Assume that the economy of Robsville is currently in long-run equilibrium, with a natural rate of unemployment equal to 6% and an inflation rate of 2%.

a) Draw a correctly labeled graph of the short-run Phillips curve, and label the curve as "SRPC". Indicate the point on the SRPC corresponding to the current unemployment and inflation rates labeled as "R".

b) On your graph in part (a), draw the long-run Phillips curve, and label it as "LRPC".

c) Assume that the government of Robsville enacts a significant tax increase. How will such a tax increase affect unemployment and inflation in the short-run? Explain.

d) Show on your graph in part (a) the new point on the SRPC corresponding to the new result you stated in part (c), labeled as "S".

e) Assume the government takes no fiscal policy action after the tax increase. What will happen to unemployment in the long-run? Explain.

Answer 1

a) Below is a labelled graph of the short-run Phillips curve as "SRPC". The point on the SRPC corresponding to the current unemployment and inflation rates is labelled as "R". The economy of Robsville is currently in long-run equilibrium and the natural rate of unemployment is equal to 6%. This implies that the long run Phillips curve is vertical at 6% while the short run Phillips curve is downward sloping and currently there is an inflation rate of 2%. At this level, both the short run Phillips curve and long run Phillips curve intersect.

b) The graph in part (a), includes the long-run Phillips curve as "LRPC". It is a vertical line showing no relationship between inflation and rate of unemployment. The economy is at its full employment level in the long run and therefore, there is a natural rate of unemployment at full employment level of output.

c) Assume that the government of Robsville enacts a significant tax increase. It will be a part of fiscal contraction and so this tax increase will reduce disposable income, consumption and so AD shifts to the left. This shift in the AD reduces output and inflation while simultaneously increasing the level of unemployment in the short-run. This result is based on the assumption that prices are flexible in the short run.

d) The graph in part (a) shows the new point on the SRPC corresponding to the new result and is labelled as "S". Because inflation is lower and unemployment are higher as a result, we move downwards along the short run Phillips curve.

e) Assume the government takes no fiscal policy action after the tax increase. The unemployment in the long-run will return to its full employment level as inflation is increased and short run Phillips curve is shifted up. This happens because when the AD shifts to the left reducing the inflation level, workers experience an increase in the real wage rate so they supply more labor. Hence, aggregate production is increased and AS shifts to the right. this reduces the level of inflation further and increasing the output. with changing expectation, the short run Phillips curve shifts down/left and the level of inflation is further reduced. Economy reaches to its full employment level and unemployment rate becomes equal to its natural rate.