Numerical Problems 1. Since the natural rate of unemployment is 0.06, e – 2(u – 0.06), so u – 0.06 0.5( e – ), or u 0.06 0.5( e – ). (a) Year 1: u 0.06 0.5(0.08 – 0.04) 0.06 0.02 0.08. The unemployment rate is 0.02 higher than the natural rate. The percentage that output falls short of full-employment output is 2 0.02 0.04, or 4%. Year 2: u 0.06 0.5(0.04 – 0.04) 0.06. The unemployment rate equals the natural rate, since inflation equals expected inflation. Since unemployment is at its natural rate, output is at its full-employment level. Since the output loss was 4 percentage points and inflation declined by 8 percentage points, the sacrifice ratio is 4/8 0.5. (b) Use equations: u 0.06 0.5( e – ), output shortfall 2 (u – 0.06). Year e u u – 0.06 Output Shortfall 1 0.08 0.10 0.07 0.01 0.02 2 0.04 0.08 0.08 0.02 0.04 3 0.04 0.06 0.07 0.01 0.02 4 0.04 0.04 0.06 0.0 0.0 The total output shortfall is 0.02 0.04 0.02 0.0 0.08 8-percentage points of output lost. Inflation fell by 8 percentage points. So the sacrifice ratio is 8/8 1. Notice that, compared with part a, the sacrifice ratio is higher, for this slower disinflation. 2. (a) Equating aggregate demand to short-run aggregate supply gives: 300 10(M/P) 500 P – Pe, or 300 (10 1000/P) 500 P – 50, or 10,000/P 150 P. Multiplying both sides of the equation by P and rearranging gives P2 150P – 10,000 0, which can be factored as (P – 50) (P 200) 0. This has the nonnegative solution P 50. Since Pe is also 50, the expected price level equals the actual price level, so output is at its full-employment level of 500 and the unemployment rate is at the natural rate of 6%. These are the long-run equilibrium values of the three variables as well. (b) When the nominal money supply increases unexpectedly to 1260, we again equate aggregate demand to short-run aggregate supply, which gives: 300 10(M/P) 500 P – Pe, or 300 (10 1260/P) 500 P – 50, or 12,600/P 150 P. Multiplying both sides of the equation by P and rearranging gives P2 150P – 12,600 0, which can be factored as (P – 60)(P 210) 0. This has the nonnegative solution P 60. When P 60, the short-run aggregate supply curve gives Y 500 P – Pe 500 60 – 50 510. Output of 510 is 2% above full-employment output of 500, because (510 – 500)/500 0.02. With a natural unemployment rate of 0.06, Okun’s Law gives 0.02 – 2(u – 0.06). This can be solved to get u 0.05. In the long run, Pe adjusts to equal P, output adjusts to its full-employment level of 500, and unemployment adjusts to the natural rate of 0.06. To find P, use the aggregate demand curve to get 500 300 10(1260/P), or 200 12,600/P, which can be solved to get P 63. The results of this exercise are consistent with the existence of an expectations-augmented Phillips curve. Unexpected inflation reduces unemployment in the short run. In the long run, however, inflation is higher and unemployment returns to its natural rate. Chapter 12 Unemployment and Inflation 258 3. (a) 0.10 – 2(u – 0.06) 0.22 – 2u. This is shown as the Phillips curve labeled PCa in Figure 12.6. If the Fed keeps inflation at 0.10, then u 0.06, the natural rate of unemployment. Figure 12.6 (b) With expected inflation rising to 12%, the Phillips curve is 0.12 – 2(u – 0.06) 0.24 – 2u. This is the Phillips curve labeled PC b in the figure. The higher rate of expected inflation has caused the curve to shift up relative to where it was in part (a). With the actual inflation rate at 10%, the Phillips curve equation is 0.10 0.12 – 2(u – 0.06), which has the solution u 0.07. So if the Fed tries to maintain the existing rate of inflation after a shock has raised inflation expectations, the unemployment rate increases. However, if the Fed could convince people that the inflation rate really would not rise, so that e remains at 0.10, then the short-run Phillips curve would remain at PC a, and the unemployment rate would not increase. (c) With the natural rate of unemployment rising to 0.08 at the same time that expected inflation rises to 0.12, the Phillips curve equation is 0.12 – 2(u – 0.08) 0.28 – 2u. This is the Phillips curve labeled PC c in the figure. The new short-run Phillips curve is even higher than those for parts (a) and (b). With the actual inflation rate held to 10%, the equation becomes 0.10 0.28 – 2u, which can be solved to get u 0.09. The unemployment rate rises both because the Fed holds inflation below expected inflation and because the natural rate has increased. This time, even if the Fed convinced people that inflation would remain just 10%, the unemployment rate would still rise to 8%, since the natural rate has increased to that level. 4. (a) Beginning in long-run equilibrium, with M 4000, output must be at its full-employment level of 6000 and the unemployment rate must be equal to the natural rate of .05. Using the values for Y and M in the AD curve, 6000 4000 2(4000/P), which gives P 4. This is also the expected price level. Because M has been constant for a long time and is expected to remain constant, e 0. Chapter 12 Unemployment and Inflation 259 (b) With P e 4, the SRAS curve is Y 6000 100(P – 4). The AD curve is Y 4000 2(4488/P). The intersection of the two curves occurs when 6000 100(P – 4) 4000 2(4488/P). Simplifying terms gives 100P2 1600P – 8976 0, which has the solution P 4.4. Plugging this into the SRAS curve gives Y 6040. From the Okun’s Law equation we get (6040 – 6000)/6000 –2 (u – .05), so – 0.00333 u – .05, so u .0467. Cyclical unemployment is u – u –.0033. Unanticipated inflation is (P – Pe)/Pe .10 10%. (c) The Phillips curve equation is e – h(u – u ), which gives .10 0 – h(.0467 – .05). This is solved to get h 30. So the slope of the Phillips curve is –30. Analytical Problems 1. (a) The reduction in structural unemployment would reduce the natural rate of unemployment and thus would shift both the expectations-augmented Phillips curve and the long-run Phillips curve to the left. (b) Despite the expense of the government program to reduce structural unemployment, it would have a permanent effect. Monetary expansion can work only temporarily—in the long run it has no effect. 2. The slope of the short-run aggregate supply curve will be much steeper in economy B, because producers increase their output only a small amount in response to an increase in price. But economy A’s short-run aggregate supply curve will be flatter, as people are likely to perceive price changes as changes in relative price rather than the aggregate price level, and thus will respond more strongly to changes in prices. The short-run Phillips curve will also be steeper in economy B, since unemployment, like output, won’t respond much to a change in inflation. But in economy A, unemployment and output will respond more strongly to price changes, and the short-run Phillips curve will be flatter. 3. (a) In Figure 12.7, the SRAS curve shifts up 10% each year, as does the AD curve. Unanticipated inflation is zero, as both actual and expected inflation are 10%. The economy is at full employment, since firms set their prices to exactly match the increase in the general price level. Figure 12.7 Chapter 12 Unemployment and Inflation 260 (b) The surprise increase in the money supply at mid-year leads to a rise in output, as shown in Figure 12.8 by the shift of the AD curve from AD1 to AD2. Firms don’t adjust their prices, so the SRAS curve remains fixed at SRAS1. When the money supply rises by its regular 10% at the end of the year, the AD curve shifts up to AD3 and firms raise their prices by 15%, shifting the SRAS curve up to SRAS3. Actual inflation is 15%, but expected inflation was only 10%. As a result, there was a temporary increase in output above its full-employment level, and a temporary decline in unemployment below the natural rate. Thus for the year as a whole, cyclical unemployment was negative and unanticipated inflation was positive, just as in the expectations- augmented Phillips curve. Figure 12.8 4. In the cashless society, there would be no shoe-leather costs, as there would be no cash balances on which to economize. But menu costs would remain for anticipated inflation. The costs of unanticipated inflation would remain as well: both the risk of wealth transfers plus confusion in price signals. 5. (a) Figure 12.9 shows the effects of increasing the money supply while holding the price level constant. Beginning at point A, the intersection of aggregate demand curve AD1 and short-run aggregate supply curve SRAS1, the increase in the money supply shifts the aggregate demand curve to AD2. Since prices cannot rise, the short-run equilibrium is at point B, with output above its full-employment level. Chapter 12 Unemployment and Inflation 261 Figure 12.9 (b) When the price controls are removed, the price level will jump up, with the short-run aggregate supply curve shifting to SRAS2. The new equilibrium is at point C, where there is full employment. 6. (a) A new law that prohibits people from seeking employment before age eighteen is likely to reduce the natural rate of unemployment because teenagers have a higher-than-average unemployment rate. With no teenagers allowed in the labor force, the average unemployment rate would be lower. (b) A service that makes looking for a job easier is able to match people and jobs more rapidly, which should reduce the natural rate of unemployment. (c) If unemployed workers can receive benefits longer, they’ll be in less of a rush to take a job, so the job-matching process will take longer. As a result, the natural rate of unemployment will rise. (d) A structural shift in the types of products people buy is likely to raise the natural rate of unemployment, because it will take time for the economy to shift workers from some types of occupations to others. (e) A recession leads to a rise in cyclical unemployment, but doesn’t affect the natural rate of unemployment. However, if there’s hysteresis, the natural rate of unemployment might rise in the future.