Answer Happy

3. Answer both parts (a) and (b) of this question.
(a) [8 marks] Explain the main features of the trade-off between
inflation and unemployment implied by the Phillips curve when
expectations are not considered in the analysis.
(b) Assume that the Phillips curve for a given economy is given
by: 𝜋𝜋𝑡𝑡 = 𝜋𝜋𝑡𝑡−1 − 0.5(𝑢𝑢𝑡𝑡 − 0.06), where 𝜋𝜋𝑡𝑡 is the inflation
rate at time t and 𝑢𝑢𝑡𝑡 is the unemployment rate at time t.
(i) [6 marks] Explain the concept of the natural level of
unemployment using the above Phillips curve.
(ii) [6 marks] Draw the short-run and the long-run Phillips
curve in the same graph. Explain the main differences between the
two.
(iii) [5 marks] Suppose that the Central Bank wants to reduce
the inflation rate in period t by 5%. According to the Phillips
curve defined above explain the effects of this policy in the short
run. Find the sacrifice ratio for this policy assuming the Okun’s
law implies a 2% reduction in real GDP for a 1% increase in the
unemployment rate.