Reading 25: U.S. Inflation, Unemployment, and Business Cycles 2011, including, Business, describe, natural

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Session 6: Economics: Monetary and Fiscal Economics
Reading 25: U.S. Inflation, Unemployment, and Business Cycles

LOS e: Explain the impact of inflation on unemployment and describe the short-run and long-run Phillips curve, including the effect of changes in the natural rate of unemployment.

 

 

Analysis using the AS-AD model suggests that if expected inflation equals actual inflation:

A) unemployment will fall.

B) unemployment will rise.

C) the economy will remain at full-employment GDP.

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AS-AD model analysis indicates that if expected and actual inflation are equal, the economy will remain at full-employment GDP.

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What would be the impact of an unanticipated increase in aggregate demand on an economy’s rate of unemployment, rate of inflation, and the short-run Phillips curve (SRPC)?

Unemployment

Inflation

SRPC

A) Decrease Decrease Downward shift of curve

B) Increase Increase Downward movement along curve

C) Decrease Increase Upward movement along curve

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Assume that the expected inflation rate is 8 percent a year and that the natural rate of unemployment is 5 percent for an economy. An unanticipated increase in aggregate demand will cause firms to hire more workers in the short-run. That action should reduce the economy’s unemployment rate below its natural rate. However, as aggregate demand increases the inflation rate will increase. This joint action would result in an upward movement along the short-run Phillips curve.

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The Phillips curve shows the trade-off between:

A) the rate of change in the money supply and the rate of change in employment.

B) aggregate demand and the real wage rate.

C) inflation and unemployment.

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The theory of the Phillips curve is that there is an inverse relationship between the inflation rate and the unemployment rate.

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Consider an economy operating at full employment, but with a high inflation rate. Based on the short-run Phillips curve, an unexpected decrease in money supply growth is likely to result in the following changes in the unemployment rate and inflation rate:

Unemployment rate

Inflation rate

A) Increase Remain above the desired rate

B) Increase Fall to the desired rate

C) Remain unchanged Fall to the desired rate

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The short-run Phillips curve illustrates the downward-sloped short-run relationship between inflation and unemployment. According to an analysis of the Phillips curve, an unexpected decrease in the growth of the money supply will cause inflation to remain above the desired rate, and will cause the economy to fall into a recession (high unemployment). For example, because the change in Fed policy is unexpected, households will continue to have high inflation expectations and will negotiate commensurately high wage increases. Therefore, inflation will not drop significantly even though the Fed has tightened the money supply growth. Moreover, as illustrated by the Phillips curve, the unexpected decrease in money supply growth combined with high inflation expectations will throw the economy into a recession (high unemployment).

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In the Phillips curve model of the relationship between inflation and the unemployment rate, a shift to a new short-run Phillips curve represents a change in the:

A) actual inflation rate.

B) unemployment rate.

C) expected inflation rate.

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A short-run Phillips curve is constructed assuming a particular expected inflation rate, given a constant long-run Phillips curve at the natural rate of unemployment. Changes in the actual inflation rate or the short-run unemployment rate would represent movement along the short-run Phillips curve. If actual inflation is sustained above or below the expected inflation rate, inflation expectations adjust in the long run. This would be seen as a new short-run Phillips curve that intersects the long-run Phillips curve at the new expected inflation rate.

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For an economy operating at full employment, if actual inflation is less than expected inflation, what will most likely be the effects on the unemployment rate in the short run and in the long run?

Short run

Long run

A) Decrease No effect

B) Increase No effect

C) Increase Increase

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Using the Phillips curve model, if actual inflation is less than expected inflation, the short-run effect is to reduce GDP growth and increase the unemployment rate. If the lower inflation rate is maintained, in the long run it becomes the new expected inflation rate, and unemployment returns to its natural rate.

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Which of these factors is least likely to change the natural rate of unemployment?

A) Labor market deregulation makes it easier for workers to change jobs.

B) Long-term demographic shifts result in fewer young adults in the labor force.

C) An unexpected tightening of the money supply reduces aggregate demand.

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The natural rate of unemployment is the sum of frictional and structural unemployment. An unexpected decrease in the money supply would bring about cyclical unemployment. The natural rate is influenced by such factors as composition and mobility of the labor force and the level of technology available in the economy.

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A shift in the long-run Phillips curve represents a change in the:

A) expected inflation rate.

B) sensitivity of unemployment to changes in inflation.

C) natural rate of unemployment.

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The long-run Phillips curve represents the natural rate of unemployment. Changes in the natural rate can occur due to long-run changes in the state of technology and the size, makeup, and mobility of the labor force.

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The short-run relationship between unexpected inflation and:

A) unemployment is positive.

B) unemployment is negative.

C) actual inflation is positive.

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The relationship between unexpected inflation and unemployment is a negative one in the short run. There should be no trend in the relationship between unexpected and actual inflation—that is the difference should be zero in the long run and uncorrelated in the short run.