The expectations augmented Phillips Curve has the form: pi = pi^e = epsilon(u -

Question

The expectations augmented Phillips Curve has the form: pi = pi^e = epsilon(u - u). Suppose that currently in the economy we have, Delta M/M = pi = pi^e = 20%, u = u* = 5% and some points along the expectations augmented Phillips Curve are illustrated in the table below. (a) Given the data in the table calculate the value of s in the expectations augmented Phillips Curve. (b) The central bank would like to have Delta M/M = pi = 0%. Illustrate the gradualist and cold-turkey approaches to getting inflation down using the Phillips Curve assuming adaptive expectations. In the case of the gradualist approach assume that Delta M/M = is cut in two sets; first to 10% then to 0%. Identify the maximum unemployment rate that will be reached in the case of the cold-turkey approach. (c) For the case of cold turkey, how would the adjustment process you outlined above differ if economic agents had rational expectations? [Instructions: No diagrams should be used here. Explain your answer in words. Maximum 100 words. You must enter the word count of your answer.]

Explanation / Answer

(a)- As per the given equation of the expectation augmented Philips curve we will put the data to find .

0.24 = 0.2- (0.03-0.05)

solving for , we get, e = 0.20 or 20%

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(b) AS the central bank want the inflation to be zero, they can either go for Gradualist or Cold Truky mechanism in which the money supply is reduced to shift the AD curve., moving the economy along the short run aggregate supply curve. In response to lower inflation rate, the SRAS shifts downward to SRAS’. This continues until the required inflation rate is not reached. The only difference In these two approaches I that in Gradualist, the growth rate of money is initially reduced slightly and the economy does not moves away from the natural rate of unemployement.where as in cold turkey, there is sudden cut in the growth rate of money supply which results in recession and the economy operates at lower output for some point of time.

Again in Gradualist, the inflation reduces step by step and the inflation reached the desired level gradually , where as in cold turkey there is a sudden fall in the inflation rate, and the equilibrium moves from e to e1 and then finally to e’.

In the given case, in the cold turkey, when the growth in money supply is reduced to 10%, initially then the he unemployment rate will be calculated as if the price inflation was 24%

24 = 10-2(u-5)

24 = -2u+10

4 = -2u, U = 2, unemployment will be 2

(c) Rational expectations are defined as those where expected inflation is equal to inflation target and when cold turkey is preferred as under the rational expectation, the public observes what is happening before updating themselves and they are able to separate the impact of supply shocks on the inflation rate and banks will respond efficiently..

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