2-3 pages work exclude graphs
EC1101 PROBLEM SET 8
Instructor: Ines Vilela
Inflation, Unemployment and Monetary Policy
Problem 1 (20 marks)
Consider the following statement:
“The Phillips curve implies that when unemployment is high, inflation is
low, and vice versa. Therefore, we may experience either high inflation or
high unemployment, but we will never experience both together”.
Is this statement true, false or uncertain? Briefly explain.
Problem 2 (40 marks)
Answer the following questions and illustrate using the feasibility set (MRT) and the
policymakers preferences (MRS).
(a) What would the policymaker’s indifference curves look like if the policymaker cared
only about low unemployment? Which point on the Phillips curve would that poli-
cymaker choose?
(20 marks)
(b) What would the policymaker’s indifference curves look like if the policymaker cared
only about low inflation? Which point on the Phillips curve would this policymaker
choose?
(20 marks)
Problem 3 (40 marks)
Consider an economy in the medium-run equilibrium (where the wage-setting and
the price-setting curves cross). Suppose that more workers join trade unions, which in-
creases their bargaining power against employers. Assume that the level of employment
and the labour supply remain constant in the short run.
(a) Using the labour market diagram show what happens to unemployment and real
wages in the labour market in the medium run.
(20 marks)
(b) Using the bargaining gap concept, explain what happens to wages, prices and in-
flation as the economy adjusts from the initial equilibrium to the new equilibrium.
Show on the Phillips curve diagram what happens to inflation.
(20 marks)
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INFLATION, UNEMPLOYMENT AND MONITORY POLICY
Submitted by:
Minjie Fam
Overall grade
20/50
Problem 1
Yes, it is true. In the Philips curve, the inflation rate may be low in circumstances when the rate of unemployment is high. We may say that the Philips curve expresses the rate at which inflation and unemployment in the economy relate. The main topic of discussion in the Phillips curve is unemployment and inflation. The two refer inversely because as the rate of employment increases, the level of inflation goes down. In the long run, the relationship between the two may, in turn, become unilinear. The Philip’s curve shares the same components with the aggregate demand for goods and services. As found in Phillip’s curve, the inflation and unemployment rates tend to be equal to the GDP as the price levels balance the aggregate demand. Comment by Abdullah: How is this true?? I really don’t understand your reasoning. Nothing makes sense. Did you go through my class presentation? You should contact me soon
It is found that the changes in the aggregate demand seem to translate its movement along Phillip’s curve. For example, having changes in aggregate demand like that one of demand-pull inflation, Phillip’s curve this time round might tend to move upwards. As the aggregate demand increases in Phillip’s arc, the real GDP and the price level will increase. Based on the assumptions of the rise in aggregate demand, the real GDP and the unemployment rate will be lowered. The result of low GDP and price level leads to increased inflation.
In the natural rate hypothesis, the theory predicts that inflation will be stable only when unemployment is equal to the standard unemployment rate. If the unemployment rate is less than the standard unemployment rate, inflation will accelerate. In the long run, if there are efforts made to decrease unemployment below the natural unemployment rate, it can be translated to inflation. The behavior will, in turn, bring changes to the inflation expectations of employees; hence the employees will try to fix their nominal wages to cater to their needs.
Problem 2
a) If the policymaker prefers a low unemployment level, then indifference curve (I1). Comment by Abdullah: Somewhat true. Good work in Q2) but still lacks many reasoning.
Therefore, the policymaker will choose the equilibrium at point E1, then the inflation rate will be high at W1, while unemployment will be low at U1.
b) If the policymaker prefers the low unemployment level, his indifference curve would be at I2. In this case, the policymaker will be at equilibrium at point E2, where the indifference curve becomes tangent to Phillip’s curve. A low inflation rate is experienced at point W2, but a high unemployment loop at point U2 is shared.
Problem 3
In the well-competitive markets for labor, the equilibrium wage rate and the employment level are considered a result of market demand for work which equalizes prices, a
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