Question

Recall that the Phillips curve can be expressed as ∆?? = ?̅?̃

? + ?̅. For each scenario below,

illustrate and describe what happens to the Phillips curve.

a. An increase in electricity prices increases costs for firms.

b. A recession hits the economy that decreases output below potential.

c. An increase in immigration that pushes wages down across the country

d. The sensitivity of inflation to changes in output increases

Answer 1

a.This is a cost-push inflation factor. An increase in electricity prices increases costs to the firms, which the firms try to pass on in the form of higher prices,thus leading to inflation. this leads to a movement along the phillips curve,with raised inflation, unemployment levels comes down.

b. This is a demand-pull inflation factor. when a recession hits the economy that decreases output below potential from Y^* to Y₁, then the Aggregate Demand(AD) curve sfihts down from AD to AD₁. At the intersection of short run aggregate supply (SRAS) curve and the AD₁ curve, price level also comes down to P₁. Due to this recession,there is movement along the short run phillips curve(SRPC), decrease in output level leads to increase in unemployement level from natural rate of unemployment(U^*) to U₁ and inflation rate also falls down.

c. This is also a cost-push inflation factor. An increase in immigration pushes wages down across the country. This leads to decrease in cost to firms and thus a fall in general price level and thus inflation falls. with this, unemployment rises with a movement along the phillips curve.

d. When the sensitivity of inflation to changes in output increases, i.e. when v in above equation increases, then a small change in output brings large change in inflation. it takes a smaller recession to reduce the inflation rate by a percentage point.