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Macroeconomic Policy Conflicts and the Phillips Curve: Question 6

Syllabus 10.2

Multiple choice A2 1 mark

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 short-run Phillips curve and the inflation-unemployment trade-off it represents?

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Worked solution

Step 1: Distinguish a movement along the curve from a shift of the curve

A single short-run Phillips curve is drawn for a given set of inflation expectations and a given set of supply-side conditions. A change in aggregate demand (for example, a change in interest rates or fiscal policy) moves the economy along a given curve, tracing out the usual inverse trade-off between unemployment and inflation. A change that instead alters the cost of production at every level of unemployment, a supply-side shock, moves the whole curve, changing the trade-off itself.

Step 2: Classify the depreciation as a supply-side (cost-push) shock

Here, aggregate demand is explicitly unchanged, so this is not a movement along the curve. The depreciation makes imported raw materials and imported consumer goods more expensive in domestic-currency terms. Firms that rely on imported inputs face higher costs and pass some of this on in higher prices; imported consumer goods also become directly more expensive on shop shelves. This is a cost-push effect that raises the price level at every given rate of unemployment, independent of demand conditions.

Step 3: Identify the direction of the shift

Because the rise in costs pushes inflation up at every rate of unemployment, the short-run Phillips curve shifts outward (up and to the right): for any given unemployment rate, the associated inflation rate is now higher than before. This matches option B.

Step 4: Rule out the other options

  • Option A describes a movement along an unchanged curve, which requires a change in aggregate demand, not given here.
  • Option C describes the shift in the wrong direction; it would apply to a fall in import prices (for example, from an appreciation), not a rise.
  • Option D is wrong because supply-side shocks, not just demand-side policy, can shift the short-run Phillips curve.

Final answer

Option B. A depreciation that raises import prices is a cost-push shock, shifting the short-run Phillips curve outward so that any given unemployment rate is now associated with higher inflation.