Question

Suppose the government misjudges the natural rate of unemployment to be much lower than it actually is, and thus undertakes expansionary fiscal and monetary policy to try to achieve the lower rate. Use the concept of the short-run Phillips Curve to explain why these policies might at first succeed. Use the concept of the long-run Phillips Curve to explain the long-run outcome of these policies. Be sure to explain fully.

Answer 1

answer is given below

Step-by-step explanation:

• There is a trade-off between unemployment and inflation in the short term. Government expansion policy should reduce unemployment as aggregate demand increases. However, the government has misinterpreted the natural rate and will continue its expansion policy beyond the natural level of unemployment.

• As aggregate demand increases, prices begin to rise. In the long run, workers are demanding higher wages to offset these higher prices. Gross supply decreases toward the natural unemployment rate (to the left).

• In other words, the decrease in unemployment above the natural rate is only temporary and has a short-term increase in inflation. This results in long-term cost increases and a decrease in total supply.

• The end result must be balanced at the natural unemployment rate and the price level above the threshold. Therefore, the longitudinal curve is the vertical line, which connects the possible level with the natural rate of unemployment seen on the horizontal axis.