Question

Suppose that an economy has the Phillips curve π = π−1 − 0.5(u − un ) and that the natural rate of unemployment is given by an average of the past two years’ unemployment: un =0.5(u−1+u−2)

Suppose that the Bank of Canada follows a policy to reduce permanently the inflation rate by 1 percentage point. What effect will that policy have on the unemployment rate over time?

Answer 1

Philips curve: first period will require unemployment rate 2% points above original natural rate.(u)

π₁-π₀= -1 = -0.5(u₁-uⁿ₁) → (u₁-uⁿ₁)=2

in the next period natural rate will rise as a result of the cyclical unemployment. The new natural rate (u) will be: u= 0.5[u₁+u₀]

= 0.5[(uⁿ₁+2) + uⁿ₁]

=uⁿ₁ + 1 → natural rate of unemployment rises by 1

The unemployment will rise above the original level by two percent points in the first year and one more percent points in the every year after.