Author Question: Suppose the current inflation rate and the expected inflation rate are both 3 percent. The current ... (Read 123 times)

jman1234 · **on:** Jun 29, 2018

Suppose the current inflation rate and the expected inflation rate are both 3 percent. The current unemployment rate and the natural rate of unemployment are both 4 percent.

Use a Phillips curve graph to show the effect on the economy of a severe supply shock. If the Federal Reserve keeps monetary policy unchanged, what will eventually happen to the unemployment rate? Show this on your Phillips curve graph.

Question 2

When a government has a budget deficit, it must issue (sell) government bonds to finance the deficit.

Does it matter for the rate of inflation if the government sells the government bonds to the public or sells the government bonds to the central bank? Explain why it does or does not matter.

bulacsom · **Reply #1 on:** Jun 29, 2018

Answer to Question 1

The supply shock will shift the short-run Phillips curve up as both the actual inflation rate and the expected inflation rate will increase. The unemployment rate will also increase as the economy moves into recession. If the Fed keeps monetary policy unchanged, the recession will cause workers and firms to lower their expectations of future inflation, and the short-run Phillips curve will shift back down to its previous position. Eventually the unemployment rate will return to the natural rate of 4 percent.

Answer to Question 2

It matters greatly. When the government sells the bonds to the public the money supply does not change, but when they sell the bonds to the central bank the money supply increases. If there are large budget deficits, the money supply will increase substantially when the central bank buys government bonds. Using the quantity theory of money, the increase in money supply from the purchase of the bonds by the central bank will increase the inflation rate.