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Question 1

expectations-augmented Phillips curve

Answer 1

The cyclical unemployment rate (the difference between actual and natural unemployment rates) depends only on unanticipated inflation (the difference between actual and expected inflation).

Question 2

Anticipated increase in money supply

Answer 2

AD shifts up and SRAS shifts up, with no misperceptions.

Result: P rises, Y unchanged.
Inflation rises with no change in unemployment.

Question 3

Unanticipated increase in money supply

Answer 3

AD expected to shift up to AD 2old (money supply expected to rise 10%), but unexpectedly money supply rises 15%, so A D shifts further up to A D 2 ,new

SRAS shifts up based on expected 10% rise in money supply

Result: P rises and Y rises as misperceptions occur

Why is output above the full-employment level in year 2?
- In year 2 the 15% rate of inflation is less than the 20% rate of money growth but greater than the 10% expected rate of inflation

• Because the price level grows by less than does the nominal money supply in year 2, the real money supply, M/P, increases, lowering the real interest rate and raising the aggregate quantity of goods demanded above Y.
• Because the price level grows by more than expected, the aggregate quantity of goods supplied also is greater than Y.
• So, higher inflation occurs with lower unemployment.
  Long run: P rises further, Y declines to full-employment level.

Question 4

when the public correctly predicts AD growth and inflation

Answer 4

unanticipated inflation is zero, actual unemployment equals the natural rate, and cyclical unemployment is zero

Question 5

if AD growth unexpectedly speeds up

Answer 5

the economy faces a period of positive unanticipated inflation and negative cyclical unemployment

Question 6

an unexpected slowdown in AD growth

Answer 6

the AD curve to rise more slowly than expected; for a time unanticipated inflation would be negative (actual inflation less than expected) and cyclical unemployment would be positive (actual unemployment greater than the natural rate).

Question 7

The relationship between unanticipated inflation and cyclical unemployment implied

Answer 7

𝜋−𝜋^𝑒=−ℎ(𝑢−𝑢̅ )

Question 8

expectations-augmented Phillips curve

Answer 8

𝝅=𝝅^𝒆−𝒉(𝒖−𝒖̅ )
“actual inflation exceeds expected inflation if the actual unemployment rate is less than the natural rate”

𝜋=𝜋^𝑒 → 𝑢=𝑢̅
𝜋𝑢̅
𝜋>𝜋^𝑒 → 𝑢

Question 9

A supply shock in the classical model

A supply shock in the Keynesian model

Answer 9

• increases the natural rate of unemployment, because it increases the mismatch between firms and workers.
• reduces the marginal product of labor and thus reduces labor demand at the fixed real wage, so the natural unemployment rate rises.

So, an adverse supply shock shifts the short-run Phillips curve up and to the right.
The short-run Phillips curve will be unstable in periods with many supply shocks

Question 10

Can the Phillips curve be exploited by policymakers?

Answer 10

Classical model: NO

• The unemployment rate returns to its natural level quickly, as people’s expectations adjust
  So unemployment can change from its natural level only for a very brief time
  Also, people catch on to policy games; they have rational expectations and try to anticipate policy changes, so there is no way to fool people systematically

Keynesian model: YES, temporarily

• The expected rate of inflation in the Phillips curve is the forecast of inflation at the time the oldest sticky prices were set
  It takes time for prices and expected prices to adjust, so unemployment may differ from the natural rate for some time

Question 11

The Lucas critique

Answer 11

When the rules of the game change, behavior changes!

Lucas applied this idea to macroeconomics, arguing that historical relationships between variables will not hold up if there has been a major policy change

The short-run Phillips curve is a good example—it fell apart as soon as policymakers tried to exploit it

Evaluating policy requires an understanding of how behavior will change under the new policy, so both economic theory and empirical analysis are necessary

Question 12

The long-run Philips curve

Answer 12

• Long-run: 𝑢=𝑢̅ for both Keynesians and Classicals
• The long-run Phillips curve is vertical, since when (𝜋=𝜋^𝑒) 𝑢=𝑢̅
• Changes in the level of money supply have no long-run real effects; changes in the growth rate of money supply have no long-run real effects, either!
• Even though expansionary policy may reduce unemployment only temporarily, policymakers may want to do so for example, timing economic booms right before elections helps them (or their political allies) get re-elected.