Question

2. A well-known economic model called the Phillips Curve (in The Keynesian Perspective) describes the short run tradeoff typically observed between inflation and unemployment. Based on the discussion of expansionary and contractionary monetary policy, explain why one of these variables usually falls when the other rises.

Answer 1

A Phillips curve shows the tradeoff between unemployment and inflation in an economy. Keynesian macroeconomics argues that the solution to a recession is expansionary fiscal policy that shifts the aggregate demand curve to the right. The other side of Keynesian policy occurs when the economy is operating above potential GDP. In this situation, unemployment is low, but inflationary rises in the price level are a concern. The Keynesian response would be contractionary fiscal policy that shifts aggregate demand to the left. Contractionary fiscal policy consists of tax increases or cuts in government spending designed to decrease aggregate demand and reduce inflationary pressures. Expansionary fiscal policy consists of tax cuts or increases in government spending designed to stimulate aggregate demand and move the economy out of recession.

Keynesian macroeconomics argues that the solution to a recession is expansionary fiscal policy, such as tax cuts to stimulate consumption and investment or direct increases in government spending that would shift the aggregate demand curve to the right. The other side of Keynesian policy occurs when the economy is operating above potential GDP. In this situation, unemployment is low, but inflationary rises in the price level are a concern. The Keynesian response would be contractionary fiscal policy, using tax increases or government spending cuts to shift AD to the left. The result would be downward pressure on the price level, but very little reduction in output or very little rise in unemployment.