Macroeconomic Policy Conflicts and the Phillips Curve: practice questions

Question 1

The economy of Cedar Falls currently has an unemployment rate of 6% and an inflation rate of 3%. The central bank sharply cuts interest rates to stimulate aggregate demand and reduce unemployment. According to the traditional (short-run) Phillips curve, which combination of chan…

Accepted Answer

A

Question 2

The government of Solantis pursues an expansionary demand-side policy over three years, aiming to keep cutting the unemployment rate. The table shows Solantis's unemployment rate and inflation rate at the end of each year. Year Unemployment rate (%) Inflation rate (% per annum)…

Accepted Answer

((a)) Year 1 to Year 2 - unemployment falls by 2.5 percentage points and inflation rises by 3.5 percentage points; Year 2 to Year 3 - unemployment rises by 0.2 percentage points and inflation rises by 4.0 percentage points  ((b)) Unemployment fell while inflation rose, which is exactly the inverse relationship traced out by a movement along a single downward-sloping short-run Phillips curve  ((c)) Once workers and firms had experienced the Year 1 to Year 2 rise in inflation, they raised their expected inflation, shifting the short-run Phillips curve upward, so further demand-side stimulus in Year 3 mostly just raised inflation (6.0% to 10.0%) rather than lowering unemploy…

Question 3

Meridia's unemployment rate has been persistently above its historical average. To reduce unemployment, Meridia's government cuts income tax rates and increases spending on public infrastructure, an expansionary fiscal policy. (a) Explain how this expansionary fiscal policy is i…

Accepted Answer

((a)) Cutting income tax raises households' disposable income and higher infrastructure spending directly adds to government spending, both raising aggregate demand; as firms respond to higher demand by producing more, they take on more workers, so demand-deficient unemployment falls  ((b)) Inflation conflict - pushing aggregate demand up towards the economy's capacity can create demand-pull inflation; current account conflict - higher disposable income raises spending on imports, worsening the current account balance  ((c)) A supply-side policy such as government-funded retraining to reduce occupational immobility raises productive capacity and can lower structural/frictional unemployment directly, so unemployment falls without relying on extra demand-pull pressure on inflation

Question 4

A government wants to reduce its unemployment rate without causing an unacceptable rise in its rate of inflation. (a) Explain, using the concept of the short-run Phillips curve, why using demand-side policy alone to reduce unemployment risks a conflict with the objective of low…

Accepted Answer

((a)) The short-run Phillips curve shows an inverse relationship between unemployment and inflation, so demand-side policy that raises aggregate demand to lower unemployment tends to push the economy closer to its productive capacity, generating demand-pull inflation as a side effect  ((b)) Supply-side policy can genuinely reduce (but not eliminate) the trade-off by lowering the natural rate of unemployment and raising productive capacity without directly raising demand, though it faces long time lags, uncertain effectiveness and works best on structural/frictional…

Question 5

Astara's government has introduced a series of policies, large increases in infrastructure spending and tax incentives for business investment, explicitly aimed at raising Astara's rate of economic growth. (a) Explain how a faster rate of economic growth in Astara could worsen i…

Accepted Answer

((a)) Faster growth raises household and firm incomes, and via the marginal propensity to import, spending on imported goods, services, machinery and materials rises; if imports grow faster than exports, the current account balance worsens  ((b)) Growth driven by expanding infrastructure and business investment typically raises resource extraction, energy use and industrial output, increasing pollution, emissions and depletion of natural resources unless the growth is decoupled from environmental damage, conflicting with…  ((c)) The gains from investment-led growth may flow disproportionately to owners of capital, higher-skilled workers or particular regions/sectors rather than being spread evenly across the population, widening the gap between rich and poor

Question 6

Kestrelle's currency depreciates sharply on the foreign exchange market, significantly raising the domestic price of imported raw materials and imported consumer goods. Assuming there is no change in aggregate demand, what is the most likely effect of this depreciation on the sh…

Accepted Answer

B

Question 7

Palmira's currency, the corona, is currently valued at 1 corona = $0.50 on the foreign exchange market. Palmira's central bank pursues a policy of managed depreciation, allowing market forces to push the exchange rate down to 1 corona = $0.40, in order to make Palmira's exports…

Accepted Answer

((a)) The dollar value of the corona falls by 20%, calculated as 0.40-0.50/0.50×100=-20%  ((b)) The depreciation makes Palmira's exports cheaper in foreign-currency terms and imports dearer in corona terms, so (assuming demand for exports and imports is responsive enough to these price changes) export volumes rise and import volumes fall, raising net exports, aggregate dem…  ((c)) The same depreciation makes imported raw materials, machinery and imported consumer goods more expensive in corona terms, raising firms' costs and shop prices directly, which is cost-push inflation that conflicts with Palmira's low-inflation objective

Question 8

Nordavia is a small economy whose main export is copper. Global copper prices rise sharply on world commodity markets, significantly increasing the revenue earned by Nordavia's copper exporters, with no change in government policy. (a) Explain how this rise in copper export reve…

Accepted Answer

((a)) Higher copper export revenue raises the incomes of copper exporters, who hire more workers directly, and the extra spending this generates raises demand for labour in other sectors too through the multiplier process, so demand-deficient unemployment falls  ((b)) Rising incomes and spending across the economy raise aggregate demand, and if Nordavia is already close to its productive capacity this creates demand-pull inflationary pressure, so the rate of inflation is likely to rise  ((c)) The higher copper export revenue is itself a credit item on the current account, so, provided import spending does not rise by an equal or greater amount, Nordavia's current account balance improves

Question 9

Doverath's rate of inflation has risen well above the government's target range. To bring inflation back down, the central bank raises its policy interest rate sharply. (a) Explain, using the short-run Phillips curve, why raising interest rates to reduce inflation is likely to i…

Accepted Answer

((a)) Higher interest rates raise the cost of borrowing and reward saving, discouraging consumption and investment, so aggregate demand falls, firms cut output and lay off workers, moving the economy along the existing short-run Phillips curve to a point of lower inflation but higher…  ((b)) Higher interest rates attract inflows of foreign financial capital seeking higher returns, raising demand for Doverath's currency and causing it to appreciate, which makes exports dearer abroad and imports cheaper at home, tending to reduce net exports and so conflicting with gr…

Question 10

A government wants to raise its rate of economic growth, reduce unemployment, keep inflation low, and improve its current account of the balance of payments, all at the same time. Which of the following policies is most likely to make progress towards all four objectives togethe…

Accepted Answer

B

Macroeconomic Policy Conflicts and the Phillips Curve: Economics 9708 (Cambridge International AS & A Level)

Syllabus coverage

Question 1

Question 2

Question 3

Question 4

Question 5

Question 6

Question 7

Question 8

Question 9

Question 10