Question

What are the differences between an economy with a vertical ERU curve and an economy with a downward-sloping ERU curve?

Answer 1

In an economy with a vertical ERU a certain level of equilibrium unemployment is found while in downward sloping ERU there are many constant inflation equilibria. . Downward sloping ERU curve shows that households consume domestic and foreign goods.This says that rise in real exchange rate gives rise to real wages by lowering real cost of imports.The most important implication of downward sloping curve is that low level of unemployment and as a result higher output can be maintained without inflationary rise in prices.Thus demand shock which is positive will lead the economy to a level of new equilibrium with lower unemployment and higher output.However,an economy with vertical ERU , a demand shock which is positive will have no effect on output.In both the cases , the new equilibrium which is attained is medium run .This new equilibrium will lead to rise in real exchange rate.Trade balance and government budget balance will become worse.