Chapter 28, Problem 28.1.2RQ

To determine

The actions of FED to move from high unemployment and lower inflation to low unemployment and high inflation point on Phillips curve.

Explanation of Solution

The Phillips curve is used by the economists to depict the short-run relation between the inflation rate and the unemployment rate in an economy. The inflation rate and the unemployment rate are the two evils which every economy tries to minimize in the short-run as well as in the long-run. But, the government cannot reduce them both at the same time. When they focus on reducing the unemployment rate, it will lead to an increase in the inflation rate and vice versa. This trade-off between the inflation rate and unemployment is explained with the help of the Phillips curve.

In order to eradicate unemployment, the FED would like to take the expansionary monetary policy which injects new money to the economy with which the per capita income of the people will increase and induce the consumption and production in the economy; this will in turn increase the demand for labor and reduce the rate of unemployment in the economy. But at the same time, the increase in the demand will also lead to an increase in the price level in the economy.

Thus, the expansionary monetary policy by the FED increases the aggregate demand of the economy, which will cause the real GDP to increase along with the price level and lowering the rate of unemployment in the economy. So in order to move from a point on Phillips curve which represents higher unemployment rate with lower inflation rate to a point where the unemployment rate is lower and the inflation rate is higher, the FED should undertake the expansionary monetary policy.

Economics Concept Introduction

Concept introduction:

Phillips curve: Phillips curve shows the relationship and trade-off between the inflation rate and unemployment rate in an economy during the short-run period.