Question

Suppose the economy is in a long-run equilibrium.

a. Draw the economy’s short-run and long-run Phillips curves.

b. Suppose a wave of business pessimism reduces aggregate demand.
Show the effect of this shock on your diagram from part a. If the Fed
undertakes expansionary monetary policy, can it return the economy to
its original inflation rate and original unemployment rate?

c. Now suppose the economy is back in long-run equilibrium and then the
price of imported oil rises. Show the effect of this shock with a new
diagram like that in part a. If the Fed undertakes expansionary monetary
policy, can it return the economy to its original inflation rate and original
unemployment rate? If the Fed undertakes contractionary monetary
policy, can it return the economy to its original inflation rate and original
unemployment rate? Explain why this situation differs from that in part b.

Answer 1

Below in correct order (a, b, and c) is the economy's short-run and long-run Phillips curves and others.

The Phillips curve depicts an inverse relationship between inflation and unemployment, where inflation rises as unemployment decreases. In the long run, the Phillips curve is a straight line at the natural rate of unemployment, indicating no trade-off. In the short run, it is a downward-sloping curve due to the inverse relationship between inflation and unemployment during this period.

b. A decrease in aggregate demand (AD) results in falling prices, causing movement along the Short-Run Phillips Curve (SRPC) from an initial inflation rate (i) to a lower inflation rate (i1) and an increase in unemployment from Un to U1. The Fed's use of expansionary monetary policy effectively raises the money supply (Ms), increasing AD and returning both inflation and unemployment rates to their initial levels.

c. Rising imported oil prices lead to increased inflation, moving from an initial inflation rate (i) to a higher rate (i1) and a decrease in unemployment from Un to U1. Contractionary monetary policy by the Fed effectively decreases the money supply, lowering AD, and restoring inflation and unemployment rates to their initial equilibrium levels. This differs from question b, where a fall in AD caused a decrease in inflation, while in part c, inflation increases due to higher oil prices.