Question

Suppose that a fall in consumer spending causes a recession.

a. Illustrate the immediate change in the economy using both an
aggregate-supply/aggregate-demand diagram and a Phillips-curve
diagram. On both graphs, label the initial long-run equilibrium as point A
and the resulting short-run equilibrium as point B. What happens to
inflation and unemployment in the short run?
b. Now suppose that over time expected inflation changes in the same
direction that actual inflation changes. What happens to the position of
the short-run Phillips curve? After the recession is over, does the
economy face a better or worse set of inflation–unemployment
combinations? Explain.

Answer 1

In the short run, a fall in consumer spending causing a recession leads to a decrease in both output and price level. Over time, if expected inflation changes in the same direction as actual inflation, the short-run Phillips curve will shift vertically upwards resulting in higher inflation and unemployment.

Step-by-step explanation:

a. In the immediate response to a fall in consumer spending causing a recession, the aggregate demand (AD) curve will shift to the left, resulting in a decrease in both output and price level. On the AD/AS diagram, this can be seen as a movement from point A (long-run equilibrium) to point B (short-run equilibrium). The shift in AD causes a decrease in both inflation and employment in the short run.

b. Over time, if expected inflation changes in the same direction as actual inflation, the short-run Phillips curve will shift vertically upwards. After the recession is over, the economy will face a worse set of inflation-unemployment combinations because both inflation and unemployment will be higher than before.