Answer to Question #125561 in Macroeconomics for Nil Su Cetinoglu

Question

a. If (inflation expectation t) = (inflation t-1), from the expectations-augmented Phillips curve it follows that, to bring the
unemployment rate below its natural level, policymakers must be willing to tolerate an
increase in the rate of inflation.
b. The smaller the fraction of wages indexed to the inflation rate, the larger the increase in
inflation associated with any given decrease in the rate of unemployment.

Answer 1

a.Friedman and Phelps also argued that if the government tries to maintain low unemployment by allowing higher inflation, then the relationship should eventually disappear. Unemployment cannot be constantly below a certain level, that very natural level of unemployment. The events of the 1970s confirmed that they were right: the relationship between unemployment and inflation has indeed disappeared. Today, most economists recognize the concept of natural unemployment.

It is here that the so-called modified Phillips curve takes its history. Because in conditions of always positive inflation, expecting zero inflation becomes stupid, wage-setting agents begin to believe that inflation this year should be about the same as in the previous one, in short, inflation expectations are being rebuilt. I will not pay attention to the conclusion of a new type of curve, I only note that the modified Phillips curve turned into a relationship between the change in inflation and the difference between the actual and natural unemployment rates: when the actual unemployment rate is higher than natural, the inflation rate decreases; when actual unemployment is lower than natural, inflation rises.

It turns out that the natural level of unemployment is the level of unemployment that is required to maintain inflation at a constant level.

politicians must endure

b.

An important point is the fact that for different periods for the same country or for different countries, the natural unemployment rate varies. Moreover, the sensitivity between changes in inflation and changes in unemployment may also differ from country to country or from period to period. Current estimates of the natural unemployment rate in the United States tell us that it has declined compared to its 6% level relevant for the 1970s. In the event that the natural unemployment rate decreases, a lower level of actual unemployment will be paired with a lower inflation rate.