Exhibit 17-5 Short-run and long-run Phillips curve Suppose the government shown in Exhibit 17-5 uses contractionary monetary policy to reduce inflation from 9 to 6 percent. If people have adaptive expectations, then: A) the economy will remain stuck at point E₁. B) the natural rate will permanently increase to 8 percent. C) unemployment will rise to 8 percent in the short run. D) unemployment will remain at 6 percent as the inflation rate falls.

Question

Quizplus · Accepted Answer

According to the short-run Phillips curve, as inflation decreases, unemployment will increase in the short run. Therefore, if the government uses contractionary monetary policy to reduce inflation from 9 to 6 percent and people have adaptive expectations, unemployment will rise to 8 percent in the short run. This is shown by the movement from point E₁ to point ES2U2B21S2U2B0 on the graph. The natural rate of unemployment is not affected by this policy, so choice B is incorrect. Choice A is incorrect because the economy will adjust in the short run, as explained above. Choice D is incorrect because it assumes that the Phillips curve is vertical, or that there is no trade-off between unemployment and inflation in the short run. However, this is not the case according to the Phillips curve model used in this question.

Exhibit 17-5 Short-Run and Long-Run Phillips Curve