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Philips curve and GDP growth

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					Question

Suppose that natural real GDP is constant. For every 1 percent increase in the rate of inflation
above its expected level, firms are willing to increase real GDP by 2 percent. The output ratio is
initially 100 and the inflation rate equals 2 percent.

       a) Based upon the preceding information, draw the short-run Phillips Curve.

       b) What is the growth rate of nominal GDP in the economy?

An adverse supply shock raises the inflation rate associated with every output ratio by 3
percentage points.

       c) Draw the new short-run Phillips Curve.

       d) The government chooses to follow a neutral policy in response to this shock. What
           will be the growth rate of nominal GDP? What will be the new rate of inflation?
           What will be the output ratio?

       e) If the government chose to follow an accommodating policy, what would be the new
           inflation rate? The output ratio? The growth rate of nominal GDP?

       f) If the government chose to follow an extinguishing policy, what would be the new
           inflation rate? The output ratio? The growth rate of nominal GDP?

Solution

a) Since natural real GDP is constant and actual real GDP grows by 2 percent for every 1
   percent increase in the inflation rate above its expected level, the following
   combination of output ratio & inflation rate will exists along the short-run Phillips
   curve, SP.
b) Since the inflation rate equals the growth rate of nominal GDP at points on the long-run
   Phillips curve when natural real GDP is constant, the growth rate of nominal GDP equals
   2 percent.




c) Adverse supply shock will shift the initial short run Phillips curve (SP1) upwards to SP2.
d) If government follows neutral policies, then the rise in the inflation rate and the fall in
   the actual real GDP are equal at 2 percentage points and the output ratio equals 98 and
   the rate of inflation equals 4 percent.

So, if the government chooses to follow a neutral policy, the growth rate of nominal GDP will
   be 2%.

New inflation rate = 4%

Output ratio = 98

e) If the government chooses to follow an accommodating policy, it will try to maintain
   the output ratio. In order to maintain the output ratio of 100, the new inflation rate has
   to be 5%.

Output ratio = 100

Growth rate of nominal GDP = 3% + 2% = 5%

f) If the government chooses to follow an extinguishing policy, it will try to maintain the
   inflation rate. So, the new inflation rate = 2%

Output ratio will fall to 94 because for every 1% change in rate of inflation, real output will fall
   by 2%.

Nominal GDP declines by 4%

				
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posted:6/22/2011
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