THE PHILLIPS CURVE

Chapter 4

(Exercises)

Macroeconomics I
Year 2022/2023
 EXERCISES CHAPTER 4

THE PHILLIPS CURVE

Essay Questions

1) Explain what is meant by the "wage-price" spiral.

Answer: The wage-price spiral refers to the effects of low unemployment on inflation.
Specifically, when the unemployment rate falls, the nominal wage will rise. As W rises,
firms' costs increase causing them to increase prices. As prices rise, workers will later ask
for increases in the nominal wage. This increase in W again causes firms' costs and prices
to rise and the process repeats itself.

2) Based on the 'early incarnation' of the Phillips curve, explain what effect an increase in
the unemployment rate will have on the inflation rate.
Answer: An increase in u will cause a reduction in W. As W falls, firms' costs fall. As
firms' costs fall, they will reduce the price level. This reduction in the price level
represents, in this case, deflation.

3) During which decade did the original Phillips curve break down? Also, briefly explain
why the original Phillips curve broke during this period.
Answer: The original Phillips curve broke down in the United States in the 1970s. First,
the United States was affected by oil shocks that would cause an increase in both inflation
and the unemployment rate. Second, individuals changed the way they formed
expectations of prices. Rather than assume that this year's price level would be equal to last
year's price level (i.e., zero expected inflation), individuals started to assume that previous
inflation would persist.

4) Explain how the original Phillips curve differs from the expectations-augmented
Phillips curve (or the modified, or accelerationist Phillips curve).
Answer: The original Phillips curve did not take into account the effects of changes in
expected inflation on inflation. The expectations-augmented Phillips curve did allow for
changes in expected inflation to affect actual inflation.

5) Based on your understanding of the Phillips curve, explain what happens to actual
inflation (relative to expected inflation) when the actual unemployment rate is either above
or below the natural rate of unemployment.
Answer: When the actual unemployment rate is equal to the natural rate of
unemployment, we know that actual inflation and expected inflation must be equal. In such
a case, all else fixed, inflation will not change. If the actual unemployment rate were to fall
below the natural rate, inflation would increase. So, the natural rate of unemployment rate
may also be referred to the non-accelerating-inflation rate of unemployment. If the
opposite occurs, inflation will fall below expected.

6) Briefly comment on the predictions of economists Milton Friedman and Edmund Phelps
about the ability to exploit a trade-off between inflation and unemployment.
Answer: Both Friedman and Phelps (separately) argued that there might be a temporary
trade-off between inflation and unemployment. However, both argued that this trade-off
could not be exploited permanently. Eventually, expectations of inflation would adjust.
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THE PHILLIPS CURVE

7) Explain how a reduction in the proportion of contracts that are indexed affects the
relationship between changes in the unemployment rate and inflation.
Answer: As the proportion of labor contracts that are indexed falls, the effects of changes
in unemployment on inflation would fall. A reduction in u will cause an increase in
inflation. When inflation rises in a period, some contracts (those that are indexed) will call
for an immediate increase in wages further increasing inflation within that period. As
indexation becomes less prevalent, that secondary effect (caused by the indexed contracts)
on inflation will be reduced.

8) Why has the U.S. natural rate of unemployment fallen since the early 1990s?
Answer: Researchers have offered a number of explanations: Increased globalization and
stronger competition between US and foreign firms may have led to a decrease in
monopoly power and a decrease in the markup; The nature of the labor market has
changed; the aging of the US population; an increase in the prison population and the
increase in the number of workers on disability.

9) Explain the natural unemployment rate and its relationship to inflation rate.
Answer: The natural unemployment rate is the unemployment rate at which the inflation
rate remains constant. When the actual unemployment rate exceeds the natural rate of
unemployment, the inflation rate typically decreases; when the actual unemployment rate
is less than the natural unemployment, the inflation rate typically increases.

10) Suppose that the Phillips curve is given by

πt= πet + (m + z) − α ut,
where
πet = (1−θ) π + θ πt−1
Suppose that m = 3%, z = 2%, α = 0.8, and θ = 1.

Given this information, write out the equation for the change in the inflation rate as a
function of the unemployment rate:

πt – πt-1 = 5 – 0.8α ut,

MULTIPLE CHOICE QUESTIONS:

1) Which of the following individuals first discovered the relationship between

unemployment and inflation?
A) Solow
B) Samuelson
C) Friedman
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THE PHILLIPS CURVE

D) Phillips

2) Which of the following individuals first discovered the relationship between

unemployment and inflation for the United States?
A) Solow and Friedman
B) Samuelson and Solow
C) Friedman and Phillips
D) Friedman and Phelps

3) In which of the following decades did the Phillips curve break down for the U.S.?
A) 1940s
B) 1950s
C) 1960s
D) none of the above

4) In the Phillips curve equation, which of the following will cause an increase in the
current inflation rate?
A) an increase in the expected inflation rate
B) a reduction in the unemployment rate
C) an increase in the markup, m
D) all of the above
E) none of the above

5) The original Phillips curve implied or assumed that

A) the markup over labor costs was zero.
B) the expected rate of inflation would be zero.
C) the actual and expected rates of inflation would always be equal.
D) all of the above
E) none of the above

6) For this question, assume that individuals form expectations of inflation according to
the following equation πet = θπt-1. From 1970 on, the value of θ for this equation
A) increased over time and approached 1.
B) decreased over time and approached zero.
C) remained constant at zero.
D) remained constant at negative one.
E) none of the above

7) Assume that expected inflation is based on the following: πet = θπt-1. If θ = 1, we

know that
A) a reduction in the unemployment rate will have no effect on inflation.
B) low rates of unemployment will cause steadily increasing rates of inflation.
C) the actual unemployment rate will not deviate from the natural rate of unemployment.
D) the Phillips curve illustrates the relationship between the level of inflation rate and the
level of the unemployment rate.

8) For this question, assume that the Phillips curve equation is represented by the
following equation:
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πt - πt-1 = (m + z) - αut. Given this information, the natural rate of unemployment will be
equal to
A) m + z.
B) (m + z - α).
C) α(m + z).
D) 0.
E) none of the above

9) Which of the following will NOT cause an increase in the natural rate of
unemployment?
A) an increase in m
B) an increase in z
C) an increase in the expected inflation rate
D) a reduction in m
E) none of the above

10) For this question, assume that the expected rate of inflation is a function of past year's
inflation. Also assume that the unemployment rate is greater than the natural rate of
unemployment for a number of years. Given this information, we know that
A) the rate of inflation will approximately be equal to zero.
B) the rate of inflation should neither increase nor decrease.
C) the rate of inflation should steadily increase over time.
D) the rate of inflation should steadily decrease.
E) the inflation rate will be approximately equal to the natural rate of unemployment.

11) Which of the following explains why the original Phillips curve relation disappeared
or, as some economists have remarked, "broke down" in the 1970s?
A) individuals assumed the expected price level for the current year would be equal to the
actual price level from the previous year.
B) individuals assumed that expected inflation would be zero
C) individuals changed the way they formed expectations of inflation.
D) monetary policy became contractionary.
E) more labor contracts became indexed to changes in inflation.

12) For this question, assume that the Phillips curve equation is represented by the
following: πt - πt-1 = (m + z) - αut. Which of the following will cause a reduction in the
natural rate of unemployment?
A) an increase in m
B) an increase in z
C) an increase in α
D) an increase in actual inflation
E) an increase in expected inflation

13) Assume that expected inflation is based on the following: πet = θπt-1. If θ = 0, we
know that
A) a reduction in the unemployment rate will have no effect on inflation.
B) low rates of unemployment will cause steadily increasing rates of inflation.
C) high rates of unemployment will cause steadily declining rates of inflation.
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D) the Phillips curve illustrates the relationship between the level of inflation rate and the
level of the unemployment rate.

14) Which of the following assumptions best characterized the assumption about how
individuals formed expectations of inflation by the early 1970s?
A) expected inflation for the current year was smaller than the previous year's inflation
rate.
B) expected inflation for the current year was approximately equal to the previous year's
inflation rate.
C) expected inflation for the current year was less than the previous year's inflation rate.
D) expected inflation for the current year equal to the average inflation rate over the past
five years.
E) expected inflation for the current year equal to the average inflation rate over the past
ten years.

15) Which of the following is a true statement about the Phillips curve relationship?
The original Phillips curve
A) takes into account worker expectations about inflation.
B) is the negative relation between unemployment and inflation first observed in the
United Kingdom.
C) applies only to European countries.
D) relation has proven to be very stable across countries and over time.

16) In the late 1960s, the economists Milton Friedman and Edmund Phelps said
A) that policymakers could achieve as low a rate of unemployment as they wanted
B) that the inflation-unemployment tradeoff could not be sustained below the natural rate
of unemployment.
C) that there was no relationship between inflation and unemployment.
D) that the natural rate of unemployment would fall if inflation was high enough.

17) Policymakers can exploit the inflation-unemployment trade-off

A) only if the expected rate of inflation is zero.
B) to achieve any desired combination of inflation and unemployment
C) in the medium run but not in the short run.
D) only temporarily, because expectations adapt to higher levels of inflation.

18) Given these equations, what do you know about the relationship between the expected
price and the price?
A decrease in the expected price will result in ……… in prices.

The inflation equation:

π = πe + (m + z) − αu
is derived from the price equation:
P = Pe (1 + m) (1 − αu + z)
Given what you found above, you can see that expected inflation can impact actual
inflation through its effects on _______.
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A) nominal wages, W.
B) the markup, m.
C) the unemployment rate, u.
D) outside factors, z.

19) Assume that individuals form expectations of inflation according to the following
equation πet = πt-1. If a Phillips curve is estimated econometrically with annual data,
obtaining the expression πt - πt-1 = 𝟐%−𝟎,𝟐𝟓×𝒖t, this implies that:
A) If the unemployment rate were zero, inflation would fall by 0.25% each year.
B) If the unemployment rate were 10%, the inflation rate would increase by 2% each year.
C) The natural rate of unemployment is 8%.
D) The expected rate of inflation is always 2%.

20) Assume that individuals form expectations of inflation according to the following
equation πet = πt-1. The natural unemployment rate is 10%, the effective unemployment
rate is 14%, and the parameter α is 0.5. Then the inflation rate will be:
A) 2% higher than the previous year.
B) Same as last year.
C) 2% less than the previous year.
D) It could be higher, the same or lower than the previous year.

21) Suppose that the unemployment rate in period t in Europe is 8.5%. If we observe that
the inflation rate in period t is higher than that registered in t−1, we can infer that the
natural rate of unemployment in that area is:
A) Greater than 8.5%.
B) Equal to 8.5%.
C) Less than 8.5%.
D) We do not have enough information to say anything about the natural rate of
unemployment.

22) Suppose that (m + z) = 6% and that α = 1, in year t. If the unemployment rate in t is

4%, then the change in inflation, between years (t) and (t−1) is:
A) 2%.
B) Lower than 2%.
C) 3%.
D) -1%.

23) Assume that individuals form expectations of inflation according to the following
equation πet = πt-1, the effective unemployment rate is 10% and effective inflation is
rising. So, the natural unemployment rate will be:
A) The 10%.
B) Greater than 10%.
C) Less than 10%.
D) It cannot be known without knowing the value of the parameter α.

24) Suppose two economies, A and B, in which individuals form expectations of inflation
according to the following equation πet = πt-1. The Phillips curve are:
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Country A: πt - πt-1 = 3% − 𝟎.5×𝒖t.

Country B: πt - πt-1 = 2.4% − 𝟎.6×𝒖t.

If both economies have the same unemployment rate and inflation increases in economy A
and falls in economy B, then its effective unemployment rate is:
A) 5%.
B) 7%.
C) 3%.
D) It is not possible for the described situation to occur.

25) According to the Philips curve equation, what could cause an increase in the effective
inflation rate:
A) An increase in the expected rate of inflation.
B) A reduction in the unemployment rate.
C) An increase in the company's profit margin.
D) All the previous answers are correct.

26) Suppose that the Phillips curve is represented by the following equation , πt - πt-1 = 3%
− 𝟎.5×𝒖t where m = 15%, z = 5% and α = 2, we can say that the natural rate of
unemployment in this economy is:
A) 20%.
B) 10%.
C) 6.5%.
D) None of the above.

27) Suppose the Phillips curve is represented by the following equation πt - πt-1 = 3% −
𝟎.5×𝒖t., where μ = 15%, z = 5%, and α = 2. If the unemployment rate is 6%, then we can
say that:
A) The rate of inflation will tend to be constant.
B) The inflation rate will tend to fall.
C) The inflation rate will tend to increase.
D) None of the above.