Macroeconomic Policy Conflicts and the Phillips Curve: Question 2

Worked solution

Part (a): Calculating the changes in unemployment and inflation

The changes are simple percentage-point differences (later rate minus earlier rate), since both variables are already expressed as percentages.

Year 1 to Year 2: $\Delta u = 5.0 - 7.5 = -2.5 \text{ percentage points}$ $\Delta \pi = 6.0 - 2.5 = +3.5 \text{ percentage points}$

So unemployment fell by 2.5 percentage points and inflation rose by 3.5 percentage points.

Year 2 to Year 3: $\Delta u = 5.2 - 5.0 = +0.2 \text{ percentage points}$ $\Delta \pi = 10.0 - 6.0 = +4.0 \text{ percentage points}$

So unemployment rose slightly by 0.2 percentage points (essentially unchanged) while inflation rose sharply by 4.0 percentage points.

Part (b): Year 1 to Year 2 and the short-run Phillips curve

Between Year 1 and Year 2, unemployment fell (7.5% to 5.0%) at the same time as inflation rose (2.5% to 6.0%). This is precisely the trade-off described by the traditional short-run Phillips curve: continued expansionary demand-side policy pushed aggregate demand up, lowering unemployment as firms hired more workers to meet demand, while also generating demand-pull inflationary pressure as the economy moved closer to its productive capacity. Since the two variables moved in opposite directions together, this is consistent with a movement along a single downward-sloping short-run Phillips curve.

Part (c): Why the Year 2 to Year 3 data signals a breakdown of the trade-off

Between Year 2 and Year 3, the pattern changes fundamentally: unemployment barely moved (in fact it edged up slightly, from 5.0% to 5.2%), yet inflation accelerated sharply (6.0% to 10.0%). If the original short-run trade-off still applied, continuing to stimulate demand should have pushed unemployment down further, not left it roughly unchanged.

The expectations-augmented Phillips curve explains this. Each short-run Phillips curve is only valid for a given expected rate of inflation. During Year 1 to Year 2, workers and firms had not yet adjusted their expectations, so the government could “buy” lower unemployment by accepting higher inflation, moving along the existing curve. But having experienced actual inflation rise to 6.0% by Year 2, workers began to expect higher inflation going forward and built this into wage claims and price-setting behaviour. This shifted the short-run Phillips curve upward (outward): at the new curve, any given unemployment rate is now associated with a higher rate of inflation than before.

Because the government kept trying to hold unemployment down through continued demand-side stimulus, the main effect in Year 3 was simply to push the economy further up this new, higher short-run curve (inflation kept accelerating (6.0% to 10.0%) while unemployment could not be pushed meaningfully below roughly 5%. This is consistent with Solantis’s natural rate of unemployment being close to 5%: once expectations fully adjust, the economy returns to (or hovers near) the natural rate, and the long-run Phillips curve is vertical at that rate. Attempting to hold unemployment permanently below the natural rate does not achieve a lower unemployment rate in the long run) it only produces ever-accelerating inflation, exactly the pattern shown by the sharp jump in inflation alongside a near-static unemployment rate between Year 2 and Year 3.

Final answers

• (a) Year 1 to Year 2: unemployment $-2.5$ pp, inflation $+3.5$ pp; Year 2 to Year 3: unemployment $+0.2$ pp, inflation $+4.0$ pp
• (b) Unemployment fell as inflation rose, a movement along a single short-run Phillips curve
• (c) Rising inflation expectations shifted the short-run Phillips curve upward, so further stimulus only accelerated inflation without a lasting fall in unemployment, consistent with the economy being near its natural rate of unemployment (~5%) and a vertical long-run Phillips curve