Deck 34: The Trade-Off Between Inflation and Unemployment

Question 1

When inflation and unemployment fell together in the 1990s, some observers claimed that policy makers no longer faced a trade-off between inflation and unemployment. Were they correct

Answer 1

Rejecting inflation unemployment tradeoff is incorrect
When inflation and unemployment fell together in the 1990s, some observers claimed that policy makers no longer faced a trade-off between inflation and unemployment.
This observation is incorrect because inflation and unemployment will fall/rise together when there is a supply shock in an economy. On the other hand, tradeoff between inflation and unemployment occurs when there is a demand shock in an economy.
Hence, rejecting inflation unemployment tradeoff based on supply shock analysis is incorrect.

Question 2

Show that if the economy's aggregate supply curve is vertical, fluctuations in the growth of aggregate demand produce only fluctuations in inflation with no effect on output.

Answer 2

Fluctuation in aggregate demand will not affect output
If the supply curve is vertical, then any fluctuation in growth of aggregate demand will be adjusted only by change in price. This is explained in Figure-1.
In Figure-1, price level is measured on vertical axis and output is measured on horizontal axis.
The supply of output is fixed; hence, the supply curve is vertical. The increase in aggregate demand shifts the demand curve upward from
to
. Since the supply curve is vertical, the increase in demand will increase the price level from
to
, and output will remained unchanged at
level.
Figure - 1

Question 3

"There is no sense in trying to shorten recessions through fiscal and monetary policy because the effects of these policies on the unemployment rate are sure to be temporary." Comment on both the truth of this statement and its relevance for policy formulation.

Answer 3

The Phillips curve found that the rate of employment and output remain constant in the long run; hence, there is no tradeoff between inflation and unemployment rate. It means any change in the monetary or fiscal policy will cause only the price level to change.
Whereas there is a tradeoff between inflation and unemployment rate in short run. It means any change in the monetary or fiscal policy will have a temporary effect on both inflation and unemployment rate.
Therefore, expansionary monetary or fiscal policy to shut out recession will cause inflation rate to go up, which will lead to a temporary effect on unemployment rate.

Question 4

Long-term government bonds now pay approximately 4 percent nominal interest. Would you prefer to trade yours in for an indexed bond that paid a 3 percent real rate of interest What if the real interest rate offered were 2 percent What if it were 1 percent What do your answers to these questions reveal about your personal attitudes toward inflation

Question 5

Why is it said that decisions on fiscal and monetary policy are, at least in part, political decisions that cannot be made on "objective" economic criteria

Question 6

What is a Phillips curve Why did it seem to work so much better in the period from 1954 to 1969 than it did in the 1970s

Question 7

Explain why expectations of inflation affect the wages that result from labor-management bargaining.

Question 8

What is meant by "rational" expectations Why does the hypothesis of rational expectations have such stunning implications for economic policy Would believers in rational expectations want to shorten a recession by expanding aggregate demand Would they want to fight inflation by reducing aggregate demand Relate this analysis to your answer to Test Yourself Question 1.
Reference Test Yourself Question 1.
Show that if the economy's aggregate supply curve is vertical, fluctuations in the growth of aggregate demand produce only fluctuations in inflation with no effect on output.

Question 9

It is often said that the Federal Reserve Board typically cares more about inflation and less about unemployment than the administration. If this is true, why might presidents often worry about what the Fed might do to interest rates

Question 10

The year 2007 closed with the unemployment rate around 5 percent, real GDP barely growing, inflation above 2 percent and apparently rising a bit, and the federal budget showing a large deficit.
a. Give one or more arguments for engaging in expansionary monetary or fiscal policies under these circumstances.
b. Give one or more arguments for engaging in contractionary monetary or fiscal policies under these circumstances.
c. Which arguments do you find more persuasive