answer as much as you could Long Essay Question: Using graphs of the Phillips Cu
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answer as much as you could
Long Essay Question: Using graphs of the Phillips Curve and Aggregate Supply from chapter 14, discuss the current debate in US monetary policy. We have had a recession and the Fed has used monetary policy to vastly increase the money supply. Some people say we can still lower unemployment before inflation starts to increase. Others believe we have lowered unemployment too low and increased the money supply so much that we have big inflation coming. Analyze the two positions with our chapter 14 graphs and equations. Then comment on which position you support more 9.Explanation / Answer
This kind of policy questions are still debatable among economicst, so much that one should not be certain to any of the forecast, and must be ready to update their framework. Briefing the history about a similar scenario, the OPEC oil shock then in around 1972 only worsened the situation, as it was preceded by policy-makers beleiving, or generalizing that phillip's curve was not just in short run, but is also stable in the long run, and hence attempted to reduce unemplyment by increasing the inflation. It resulted to same (natural) unemployment rate and increased price level after some time, and then came the oil shock, which further increased the price level and pushed the US economy to recession around 1975. Yet policy-makers have learned from these events, but it is still not that much clear to what should be done, as the variables in the scenario changes from time to time, and so does the framework.
We must first look at the theories, and then we must think what should be done. In theory, there is an inflation - unemployment tradeoff in the short run, but in the long run, the unemployment returns to its natural rate. What happens with inflation depends on the policy-makers in the short run. Suppose policy-makers increases money supply, increasing price level and hence reduce unemployment (ie increase output) in the short run, but after some time, this increment in output, which can be seen as overworking of the economy is adjusted since people adjust their expectations about the price level. The expectations adjustment then reduce the overworking, and reduce the output to previous level (which was the natural rate of unemployemnt). But, the price is still increased and over that, unemployment is as before. Hence, in this case, economy moves to higher price level with same output. It can be depicted as shifting of the PC (phillip's curve) to up/right. Vice versa can be done to reduce inflation/price-level in the long run, by increasing unemployment for a short time and then returning to previous level, but now with a lower price level. In this case, the PC shifts left. Expectations plays a crucial role in the price adjustment. If people suddenly faces higher wages, they tend to work more, but after they realise that this increase in wages just reflected in higher price, and their real purchasing power is at parity, they update their expectations, and work as before, but now still facing a higher price.
Now, we know that policy-makers are concerned about recent recession's effects, and would like to increase output and reduce unemployment, but they are also expecting the results to be the same as they have definitely learnt by what happened back then in 1970's. They are now more careful and face a more improvised, yet not so different, choice. One must note that the oil shock back then also lead to changes in many regulations in international scenario, and is least expected now-a-days. So an adverse supply shock, yet should be considered as a backup plan, but can be kept aside in this case. How much of unemployment is low and what is the exact state of the economy in the PC poses huge empirical difficulties, and yet can be still estimated, but can not be exclusively trusted.
Even after analysing the immense complexity of the scenario, we may find what should be done by looking at the golas of an economy. In a nutshell, an economy's long term goals are internal balance (stable prices and unemployment), external balance (stable Balance of Payment deficit/surplus), and economic growth (growth in per capita income and standard of living, welfare, etc). The sustainable development is not included as it takes the problem to a different horizon.
So, what we know by is that the unemployment can not be reduced for-ever. It can be reduced only temporarily to cope-up according to the recent recession. But, in any case, the risk of price instability certainly exists, and the problem itself, basically, distributes as if economy is close to the potential output or is quite below the potential output. In case, economy is close to potential output, the case is where inflation is high enough and lowered unemployment is too low. In this case, the increase in money supply would push the economy to higher inflation for long run, and returning to its potential-natural level output in the long run. In case the economy is quite below the potential level, the case is where unemployment can be lowerd and price level should be increased, as it will eventually be increased. In that case, also, the result would be same as per unemployment, while inflation will not be that much hectic. But, overall, since price stability is a primary goal, and unemployment would eventually reach to its natural level whatever policy is imposed, one may choose the policy of NOT increasing price level via money supply increment, as the other case poses riskier price instability.
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