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(a) The following graphs show the levels of unemployment and inflation in the U. economy from 2000 to 2009.
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Question

1.    (a) The following graphs show the levels of unemployment and inflation in the U.S. economy from 2000 to 2009.

Are the data for u

Are the data for unemployment and inflation during the 2000s in general agreement with the Phillips Curve?

(b) Suppose that an economy has the following relationship between output and inflation:

Y =  + α(π−Eπ) and that the relationship between output and unemployment given by Y −  = −2 (  − ) holds.

Y: output

equilibrium output

inflation rate

E : expected level of inflation

u: unemployment rate

: natural rate of unemployment

i) Derive the Phillips Curve for this economy. (That is, find the relationship between unemployment and inflation)

ii) Suppose the government observes that unemployment is very high and wants to reduce it. To achieve this, it increases the money supply to raise inflation by 3 % points, which is a surprise to individuals in the economy. How much does unemployment go down? (Your answer should be in terms of α)

iii) Now suppose several years later, unemployment has gotten to be quite high again, and the government wants to reduce it again. If individuals in the economy have rational expectations, can the government use the same procedure in part (a) to lower unemployment?

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