Question

Write down the Phillips curve and describe the trade off that it implies. What happens to the Phillips Curve, and the position of the economy on a Phillips Curve in the short run and long run after the central bank decreases the growth rate of the money supply? (State which assumption you make about price expectations)

Answer 1

The Phillips curve states that inflation and unemployment have an inverse relationship. In other words, higher inflation is associated with lower unemployment and vice versa. The equation of the Phillips curve is given by

Where is the expected rate of inflation and U is the unemployment rate and U* is the natural rate of unemployment.

Assuming rational expectation, given the expected price level, which workers simply take to be last year’s price level, lower unemployment leads to a higher nominal wage. A higher nominal wage leads to a higher price level. Putting the steps together, lower unemployment leads to a higher price level this year relative to last year’s price level – that is, to higher inflation.

Suppose the central bank decreases the growth rate of the money supply that means it decreases the inflation. So in the short run rate of inflation is determined by the rate of money growth, it will help the unemployment higher along the short-run Phillips curve, but in the long-run, due to expectation, the long run Philips curve can shift inward.