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Pearson Education Materials
Workshop 10: Unemployment and Inflation
- In the equation MV = PY, describe what is meant by each of the four terms.
M
V
P
Q
- In an economy whose national income is £24 billion, the money supply is £8 billion:
- What will be the velocity of circulation?
- If national income at base-year prices is £12 billion, what is the price index?
- Suppose the velocity of circulation stays constant and the government decides to increase the money supply to £10 billion, what will happen to the price index if real national income remains the same?
- If money supply rises, will the price level rise by the same percentage? It all depends on what happens to V and Y. The effects will tend to differ in the short run from the long run. Delete the wrong words in the following statements:
- In the short run, V can change substantially / is unlikely to change much at all when money supply changes.
- In the short run, a rise in MV (i.e. a rise in aggregate demand) will lead to a rise in the price level / may or may not lead to a rise in the price level depending on the degree of slack in the economy.
- The following are the statistics for UK inflation and unemployment from 1970 to 2003.
| Inflation (%) | 6.3 | 9.4 | 7.3 | 9.1 | 16.0 | 24.3 | 16.6 | 15.8 | 8.3 | 13.4 | 18.0 | 11.9 |
| Unemployment (%) | 2.4 | 3.0 | 3.3 | 2.3 | 2.3 | 3.6 | 5.6 | 6.0 | 5.9 | 5.0 | 6.4 | 9.8 |
| Inflation (%) | 8.6 | 4.6 | 5.0 | 6.1 | 3.4 | 3.7 | 4.6 | 5.9 | 8.1 | 6.8 | 4.7 | 3.0 |
| Unemployment (%) | 11.3 | 12.4 | 11.7 | 11.2 | 11.2 | 10.3 | 8.5 | 7.1 | 6.9 | 8.6 | 9.8 | 10.2 |
| Inflation (%) | 2.4 | 2.8 | 2.9 | 2.8 | 2.7 | 2.3 | 2.1 | 2.1 | 2.2 | 2.8 |
| Unemployment (%) | 9.4 | 8.5 | 8.0 | 6.9 | 6.1 | 5.8 | 5.3 | 5.0 | 5.3 | 5.4 |
These figures are plotted on the following diagram.
- Try drawing the line of best fit through the points on the diagram. Does it look anything like a Phillips curve?
- Now try drawing four separate curves: one for the period 1970-79; one for 1980-85; one for 1986-93; and one for 1994-2003.
- (i) In which two of the four periods is there apparently a trade-off and (ii) in which one of these two is the inflation/unemployment relationship more favourable?
- How would you describe the relationship between inflation and unemployment between 1994 and 2003?
- To what extent is your diagram consistent with the Keynesian argument that the Phillips curve is downward sloping but has shifted?
- Now try connecting the points in chronological order. Describe the pattern that emerges.
- How would any apparent clockwise loops in the Phillips curve be explained by the adaptive expectations model?
- How would you account for the relationship (or lack of it) between inflation and unemployment since 1994?
- The diagram below shows two short run Phillips curves (PC0 and PC1). PC0 corresponds to a situation in which workers expect no inflation.
- What is the natural rate of unemployment?
- What is the expected rate of inflation if the Phillips curve is PC1?
Suppose that the economy begins in long-run equilibrium with zero inflation and that the authorities adopt a policy of constant monetary growth because they wish to reduce unemployment below its existing level.
- Identify the short-run effect on unemployment and inflation.
Unemployment
Inflation
- Explain why this new position for the economy is untenable in the long run.
- Towards what long-run equilibrium level of unemployment will the economy tend?
- Assume that inflation depends on two things: the level of aggregate demand, indicated by the inverse of unemployment (1/U), and the expected rate of inflation (Pet). Assume that the rate of inflation (Pt) is given by the equation:
Pt = (40/U - 4) + Pet
Assume initially (year 0) that the actual and expected rate of inflation is zero.
- What is the current (natural) rate of unemployment?
- Now assume in year 1 that the government wishes to reduce unemployment to 5% and continues to expand aggregate demand by as much as is necessary to achieve this. Fill in the rows for years 0 to 4 in the following table. It is assumed for simplicity that the expected rate of inflation in a given year (Pet) is equal to the actual rate of inflation in the previous year (Pt-1).
| Year | U | (40/U) - 4 | + | Pe | = | P |
|---|
| 0 | ____ | ____ | + | ____ | = | ____ |
| 1 | ____ | ____ | + | ____ | = | ____ |
| 2 | ____ | ____ | + | ____ | = | ____ |
| 3 | ____ | ____ | + | ____ | = | ____ |
| 4 | ____ | ____ | + | ____ | = | ____ |
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| 5 | ____ | ____ | + | ____ | = | ____ |
| 6 | ____ | ____ | + | ____ | = | ____ |
| 7 | ____ | ____ | + | ____ | = | ____ |
- Now assume in year 5 that the government, worried about rising inflation, reduces aggregate demand sufficiently to reduce inflation by 2% in that year. What must the rate of unemployment be raised to in that year?
- Assuming that unemployment stays at this high level, continue the table for years 5 to 7.
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