Inflation and Unemployment

1. You are an advisor to a newly elected prime minister. She will face new elections four year from now. Inflation last year was 3%, and the unemployment rate was equal to the natural rate. The Phillips curve is given by: pt = pt-1 - a(ut - un)

Assume you can use fiscal and monetary policies to achieve any unemployment rate you want for each of the next four years. Write a short memo to the prime minister indicating what unemployment and inflation should try to achieve.

To: Prime Minister

From: Advisor

Subject: Inflation and Unemployment

November 22, 2013

The Philips curve basically shows an inverse relationship between inflation and unemployment. This means that when unemployment will be high the wages will tend to increase slowly, and in the opposite case when unemployment will rest on the lower side wages will increase rapidly (Econlib.org, 2013).

The government uses expansionary monetary policy and fiscal policy to lower the unemployment rate well below its natural rate. As a result, firms start raising the wage prices even more than what the employees have anticipated, getting more and more employee commitment. The willingness of the firms to raise the wage rates, make the employees more committed and supply more labor due to the increase in wages. Thus, the unemployment rate falls even below the natural rate. The purchasing power of the employees also has declined due to the increase in wages that demands more supply of labor from them.

If the policy makers want to change the average rate on inflation, they try to push the unemployment rate below its natural rate. This reduction in the unemployment rate, hence, will increase the inflation rate. After a period of time the workers had the time to adjust their wage prices, and the inflation rate again demands the unemployment rate to ...