Answer to Question #208516 in Macroeconomics for Juhi

Question

Q) a. What is Phillips curve? Draw the short-run Phillips curve and the long-run Phillips curve. Explain why they are different. [2 marks]

b. Suppose the economy is in a long-run equilibrium. Suppose a wave of business pessimism reduces aggregate demand. Show the effect of this shock on your diagram from part (a). If the RBI undertakes expansionary/contractionary monetary policy, can it return the economy to its original inflation rate and original unemployment rate? (b) What is sacrifice ratio?

Answer 1

(a) Phillips curve is a curve that shows the inverse relationship between inflation and unemployment. Inflation increases as unemployment decreases.

At natural rate of unemployment, the long run Phillips curve is a straight line while the short run Phillips curve is a downward sloping curve. The short run Phillips curve occurs as a result of one quantity decreasing as the other one increases. The long run Phillips curve occurs as a straight line because there is no trade off.

(b) Reduction of aggregate demand

When aggregate demand is reduced, the aggregate demand curves will shift to the left from AD4 through to AD1. This is as illustrated below:

As aggregate demand reduces, unemployment increases as less workers are hired, the real GDP output falls and the price level also falls. As shown by the following graph, the rate of unemployment will increase all through point B to A and beyond.

a. The monetary policy can be loosened when there is a recession that has caused unemployment or tightened when there is a threat of inflation. In order to return the economy to its original inflation rate and original unemployment rate, expansionary and contractionary monetary policy should be proportionally and accordingly employed, this is because, for instance , if loose monetary policy seeking to end a recession goes too far ,it may push aggregate demand so far to the right that it may trigger inflation. on the other hand, if tight monetary policy seeking to reduce inflation goes too far, it may push aggregate demand so far to the left that it triggers a recession.

b.

Sacrifice ratio refers to an economic ratio that measures the effect of rising and falling inflation on a country's total production and output. This ratio measures the loss in output per each 1% change in inflation.