7. The costs of disinflation The following graph depicts the short-run and long-

Question

7. The costs of disinflation The following graph depicts the short-run and long-run Phillips curves (SRPC and LRPC) for a hypothetical economy in long-run macroeconomic equilibrium at point A, where the natural unemployment rate is 6% and the current inflation rate is 8% per year. 20 LRPC 18 L 12 10 SRPC 0 1 23 4 5 6 7 8 9 10 UNEMPLOYMENT RATE (Percent) Suppose that the central bank in this economy is concerned that inflation is too high and wants to lower the inflation rate by 6 percentage points per year. A reduction in the rate of inflation is known as have to accept an unemployment rate of . To reduce inflation from 8% to 2% in the short run, the central bank would True or False: If people have rational expectations, the economy may not have to endure an unemployment rate as high as predicted by the short-run Phillips curve True False

Explanation / Answer

Answer 1: A reduction in the rate of inflation is known as deflation.

Explanation: Inflation refers to an increase in the general price level. When there is a fall in the general price level, it is called deflation.

Answer 2: To reduce inflation from 8% to 2% in the short run, the central bank would have to accept an unemployment rate of 9%.

Explanation: From the Philips curve, we can see that when the inflation rate is 2%, the unemployment rate is 9%.

Answer 3: True

Explanation: If there were rational expectations, the wage level would adjust so that the unemployment level does not come down by such a margin.

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