Consider a hypothetical economy in which policy makers have never used inflation to try to stimulate the economy. Let’s say that inflation is 0 percent and market participants expect 0 percent inflation going forward. In addition, the natural rate of unemployment is 6 percent.
a. Draw a diagram representing the short- and long-run Phillips curves with expected inflation and actual inflation on the y axis and the unemployment rate on the x axis.
b. Show what happens in the short run if the central bank of this economy decides to enact policy that raises the inflation rate to 3 percent.
c. Because the inflation rate is 3 percent, market participants expect a 3 percent inflation rate. Show what impact this has on the short-run Phillips curve.
d. Discuss how this demonstrates the long-run Phillips curve.
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