Week 8

Chapter 16 (28) | |

Inflation, Unemployment, and Federal Reserve Policy

SOLUTIONS TO END-OF-CHAPTER EXERCISES

CHAPTER 16 (28)

Answers to Thinking Critically Questions

1. According to this new research, a one-time Fed-induced increase in inflation would have a larger effect on unemployment today than it would have had decades ago. This is because, according to this new research, people do not expect inflation to increase.

1. This would weaken the Fed’s ability to lower unemployment below its natural rate. This is because the Fed affects unemployment in the short run if households do not expect the inflation that the Fed causes. The Fed causes the inflation to lower the real wage and, hence, increase employment. If the public does not believe the Fed’s commitment, it will expect inflation and plan accordingly. This public reaction effectively shifts the short-run aggregate supply curve to the left, thus offsetting the effects on employment of the Fed-engineered inflation.

| |Learning Objective |

Learning Objective 16.1 Describe the Phillips curve and the nature of the short-run trade-off between unemployment and inflation.

Review Questions

1.1 The Phillips curve is a curve showing the short-run relationship between the unemployment rate and the inflation rate.

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1.2 The Fed would undertake an expansionary monetary policy. This would increase aggregate demand, causing real GDP and the price level to both increase. An increase in real GDP will increase employment, lowering the unemployment rate.

1.3 The Phillips curve during the 1960s had been stable, so it appeared that policy makers could permanently reduce unemployment if they were willing to accept permanently higher inflation. They were wrong to think of the Phillips curve as a policy menu because the short-run Phillips curve shifts when the...