Reference no: EM131103640

Short-Run Phillips Curve Assume that an economy is governed by the Phillips curve: π = Eπ − 0.5(u − 0.06), where π is the inflation rate, Eπ is the expected inflation rate, and the natural rate of unemployment is 6%. Also, note from Okun’s law that 1 percentage point of unemployment translates into 2 percentage points of lost output. Suppose that today, π = 0.05 and Eπ = 0.05. The government wants to lower inflation to 2%. Assume that people have adaptive expectations. (a) How much cyclical unemployment does the economy have to experience to have inflation rate of 2%? (b) What is the sacrifice ratio? Assume that the government announced its plans to lower inflation before the workers and firms form their expectations. The workers and firms form their expected inflation by the following rule: Eπ = απa + (1 − α)π−1, where π−1 is the inflation rate in the previous period, π a is the announced inflation, and α ∈ [0, 1] is the weight workers and firms put on the announcement (credibility of the government). (c) Suppose that households and firms fully trust the government, and thus α = 1. How much cyclical unemployment does the economy have to experience to have inflation rate of 2%? (d) Suppose α = 0.5. How much cyclical unemployment does the economy have to experience to have inflation rate of 2%? What is the sacrifice ratio? (e) How does α affect the sacrifice ratio?