Question

Consider the short-run and long-run Phillips Curves illustrated in the figure below. Suppose consumers have adaptive expectations, the inflation rate is 5 percent, and the unemployment rate is currently at 6 percent, which is the natural rate of inflation. The Federal Reserve decides that it wants to reduce the unemployment rate and uses monetary policy to do so. Describe the new short-run Phillips Curve.

Answer 1

The Federal Reserve's use of monetary policy to reduce unemployment below the natural rate shifts the short-run Phillips Curve to reflect lower unemployment at the cost of higher inflation, but the vertical long-run Phillips Curve remains unchanged, reflecting the natural rate of unemployment at varying inflation rates.

Step-by-step explanation:

When the Federal Reserve employs monetary policy to reduce unemployment below the natural rate (currently at 6 percent), it can achieve this in the short run by increasing the money supply, which leads to higher inflation expectations as consumers adapt. This results in a new short-run Phillips Curve that still slopes downward but at a higher level of inflation; let's assume inflation increases from 5 percent to a higher rate.

Essentially, there is a move from the initial short-run Phillips Curve to a new one that reflects the lower unemployment rate but at the cost of higher inflation, aligning with the concept where a downward-sloping Phillips Curve represents a short-term relationship between unemployment and inflation. This short-term trade-off is temporary, as emphasized by economist Milton Friedman, indicating that in the long run, any point on the vertical long-run Phillips Curve reflects the natural rate of unemployment, irrespective of the inflation rate.