Suppose the inflation rate if 7% and unemployment rate is 2.5%. If you were on the...

Suppose the inflation rate if 7% and unemployment rate is 2.5%. If you were on the Federal Open Market Committee, what monetary policy action would you prescribe? How would this affect the economy, the inflation rate, and the unemployment rate?

Expert Solution

Since, we know that, as per the philip curve, in short run, there is a tradeoff between inflation and unemployment rate. Which means that, higher inflation and lower unemployment rate or lower inflation and higher unemployment rate.

So, keeping this in mind, I would recomment to decrease the money supply it means the Fed should start selling bonds to the general public which means hike in interest rates. This would decrease aggregate demand in the economy which lowers the inflation. On the other hand, low aggregate demand means firms need to decrease production and they will hire less workers which causes the unemployment rate to rise. So, ultimately, the inflation rate falls and unemployment rate rises.

But in the long run, no such relatione exist. The unemployment rate is independent of inflation rate in the long run. It means that unemploymnent rate would be equal to natural rate of unemployment in the long run.

Rahul Sunny answered 1 year ago

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