The Phillips curve and the short-run aggregate supply curve are closely related, yet one slopes downward and the other slopes upward. Discuss


Q2. Explain the connection between the vertical long-run aggregate supply curve and the vertical long-run Phillips curve



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Q2. Explain the connection between the vertical long-run aggregate supply curve and the vertical long-run Phillips curve.

Both reflect the classical dichotomy. The vertical long-run aggregate supply curve says that, in the long run, the economy will be at its natural rate of output, and that this is the same no matter what the price level. The natural rate of output depends on the natural rate of unemployment. The vertical Phillips curve says that, in the long run, the economy will be at the natural rate of unemployment (corresponding with the natural rate of output), and that this is the same no matter what the inflation rate. Both curves are consistent with the classical dichotomy that says real variables are not affected by nominal variables



Q3. Suppose that the Fed unexpectedly pursues contractionary monetary policy. What will happen to unemployment in the shortrun? What will happen to unemployment in the long run? Justify your answer using the Phillips curves.


Inflation rate

P
In the short run, unemployment will rise, because, contractionary policy reduces actual inflation and so moves the economy down along the Phillips curve. In the long run, the economy will return to its natural rate of unemployment as the short-run Philip curve shifts left as inflation expectations fall.


Long-run Phillips curve

AS



A



B

A



B



C

PC1

AD1



PC2

AD2



Natural rate of unemployment

0

Unemployment rate

Y

0


Q4. What is sacrifice ratio? Suppose that the sacrifice ratio is 2.5 and some countries have inflation around or in excess of 8percent. What is the cost of reducing inflation from 8 percent to 2 percent? In your answer, define the sacrifice ratio andexplain how you found the cost of inflation reduction. Why does a downward-sloping Phillips curve imply a positive sacrifice ratio?

The sacrifice ratio is the number of percentage points of annual output lost in the process of reducing inflation by 1 percentage point.

The cost of inflation reduction = 2.5 * (8%-2%) = 10%

A downward-sloping Phillips curve implies that as a government acts to decrease inflation, unemployment increases. Increased unemployment leads to lower output. So the Phillips curve implies that inflation reduction requires a decrease in output, as does a positive sacrifice ratio.


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