1. The natural level of unemployment is the rate of unemployment that exists when the economy is in equilibrium, with no cyclical fluctuations in output or prices. In the above Phillips curve, it can be found by setting ut (the unemployment rate) equal to its natural rate, which is assumed to be constant over time. When this is done, the equation becomes: π = πt-1 – 0.03, meaning that inflation depends only on its past value, not on the level of unemployment.
2. The short-run Phillips curve shows the negative relationship between the inflation rate and the current unemployment rate. It is downward sloping, reflecting the fact that as unemployment decreases, firms must pay higher wages to attract workers, and these higher costs are passed on to consumers as higher prices. The long-run Phillips curve, on the other hand, is a vertical line at the natural rate of unemployment. This reflects the fact that in the long run, there is no tradeoff between inflation and unemployment, and the economy will converge to the natural rate regardless of the level of inflation.
3. If the central bank wants to reduce inflation by 5%, it will need to reduce the level of output below its natural level in order to put downward pressure on prices. One way to do this is to increase interest rates, which will make borrowing more expensive and reduce spending throughout the economy. This will lead to a temporary increase in unemployment and a shift in the short-run Phillips curve to the left, as shown in the diagram below. As the economy adjusts, the unemployment rate will eventually return to its natural rate, but at a lower level of inflation.
4. Okun's law states that there is a negative relationship between the unemployment rate and the level of GDP, with each percentage point increase in unemployment associated with a decrease in GDP of about 2%. Therefore, if the central bank reduces the inflation rate by 5%, and this leads to a temporary increase in unemployment of 1%, we would expect to see a corresponding decrease in GDP of about 2%. However, this relationship may not hold precisely in all cases, as other factors can also influence the relationship between unemployment and output.
Assume that the Phillips curve for a given economy is given by: π = πt-1 – 0.5 (ut – 0.06)
1. Explain the concept of the natural level of unemployment using the above Phillips curve.
2. draw the short-run and the long-run Phillips curve.
3. Suppose that the Central Bank wants to reduce the inflation rate in period t by 5%. According to the Phillips curve defined above explain the effects of this policy in the short-run.
4. By considering the Okun’s law, what is the change in GDP that will be associated with the change in unemployment rate.
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