The Phillips Curve: Inflation vs Unemployment

The Phillips Curve: Inflation vs Unemployment

1. 1. According to the expectations-augmented Phillips curve equation π = π^e − β(u − u_n), what happens to actual inflation when unemployment falls below the natural rate while expected inflation remains constant?

   Inflation decreases as firms reduce wage pressuresInflation increases because the unemployment gap (u − u_n) is negative, so the −β(u − u_n) term is positive and adds to expected inflationInflation stays constant because expected inflation anchors nominal outcomesInflation becomes unpredictable and depends only on monetary policy

2. 2. Why did the simple Phillips curve trade-off appear to break down in the 1970s?

   The natural rate of unemployment increased permanently due to technological changeExpected inflation began rising and shifted the Phillips curve upward as workers incorporated past high inflation into wage demandsThe relationship between unemployment and inflation became positive instead of negativeFirms stopped competing for workers and wages fell despite low unemployment

3. 3. What is the shape and location of the long-run Phillips curve, and what does this imply for policymakers?

   Downward-sloping; policymakers can trade unemployment for permanently lower inflationVertical at the natural rate u_n; permanent reduction in unemployment is impossible through demand-side policy aloneUpward-sloping; lower unemployment must always cause higher inflationHorizontal at the natural rate; inflation has no effect on unemployment over time

4. 4. During the 2022 inflation episode, which of the following factors supported the Fed's soft landing and helped keep expectations from coming unanchored the way they did in the 1970s? Select all that apply.

   Survey measures of expected inflation rose somewhat but stayed well below the actual 9% inflation rateBond market implied expectations remained near 2.5%, suggesting anchored long-term expectationsActual inflation had reached 9%, which automatically resets expectations downwardThe Fed tightened monetary policy aggressively to bring inflation back down before expectations drifted higher

5. 5. Suppose the natural rate of unemployment is 4%, the unemployment rate is currently 3%, and expected inflation is 2%. If β = 1 in the Phillips curve equation π = π^e − β(u − u_n), what is the current rate of actual inflation (in percent)?

   %