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Macroeconomic Policy Conflicts and the Phillips Curve: Question 1

Syllabus 10.2

Multiple choice A2 1 mark

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 changes in the unemployment rate and the inflation rate would this policy most likely produce, as the economy moves along the existing curve?

Choose an answer to check it, then compare with the worked solution below.
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Worked solution

Step 1: Recall what the short-run Phillips curve shows

The traditional (short-run) Phillips curve plots a downward-sloping, inverse relationship between the rate of unemployment (horizontal axis) and the rate of inflation (vertical axis). A single curve represents a given set of inflation expectations; moving along it shows the trade-off available to policymakers using demand-side policy at that point in time.

Step 2: Trace the effect of the interest rate cut

Cutting interest rates makes borrowing cheaper and saving less attractive, encouraging both households to spend more (consumption) and firms to invest more. This raises aggregate demand, which, assuming the economy is not already far below full capacity, raises real output and the demand for labour, so unemployment falls. At the same time, the extra spending pushes the economy closer to (or beyond) its productive capacity, creating demand-pull inflationary pressure, so the rate of inflation rises.

This is exactly a movement along a given downward-sloping short-run Phillips curve: lower unemployment, higher inflation. This matches option A.

Step 3: Rule out the other options

  • Option B (unemployment falls and inflation falls) would require the two variables to move in the same direction, which is inconsistent with the inverse relationship shown by the short-run Phillips curve.
  • Option C (unemployment rises and inflation falls) describes the effect of a contractionary, not expansionary, demand-side policy, the opposite of an interest rate cut.
  • Option D (unemployment rises and inflation rises) describes a stagflation-type outcome, which is associated with a leftward shift of the short-run Phillips curve (for example, caused by a supply shock or a rise in inflation expectations), not with a movement along the existing curve in response to an expansionary demand-side policy.

Final answer

Option A, cutting interest rates raises aggregate demand, moving the economy along its existing short-run Phillips curve to a point with lower unemployment and higher inflation.