Worked Phillips curves free response question

Assume that the United States economy is currently in a short run equilibrium with the actual unemployment rate above the natural rate of unemployment.

Part A says draw a single correctly labeled graph with both the long run Phillips curve and the short run Phillips curve. Label the current short run equilibrium point P. So like always, pause this video, get a pencil and paper out, and see if you can sketch this yourself before we work through this together. You'll get more out of this video.

All right, now let's do this together. So if we're thinking about Phillips curves, we're going to have two axes. Our horizontal axis is going to be the unemployment rate, which is going to be expressed as a percentage. Our vertical axis is going to be our inflation rate, which is also going to be expressed as a percentage.

So let's start with the long run Phillips curve. The long run Phillips curve that's just going to be fixed at the natural rate of unemployment, so that's just going to be a vertical line. So let's just put that right over there, and let me label it. That is our long run Phillips curve.

Now let's do the short run Phillips curve. Well, the short run Phillips curve shows this association between our inflation rate and our unemployment rate. High rates of inflation are associated with low unemployment, and low rates of inflation are associated with high rates of unemployment. So our short run Phillips curve is going to look something like that. Let me just label that short run Phillips curve.

Now they want us to label the current short run equilibrium point P. A lot of times when people talk about equilibrium points, it's tempting to just look at the intersection of these two curves, but that wouldn't be the case here. The equilibrium point is going to be some point along our short run Phillips curve. In fact, every point on our short run Phillips curve represents a potential equilibrium point.

If we were looking at aggregate demand versus aggregate supply, well then our equilibrium point would be at the intersection of the aggregate demand and short run aggregate supply, but here our equilibrium point could be any point along our short run Phillips curve. They say that we're currently in a place where the actual unemployment rate is above the natural rate of unemployment. So the natural rate of unemployment is here; the actual rate of unemployment is higher, but we're going to be on our short run Phillips curve. So we could be at a point just like that. So let's just label that point P.

Part B says assuming no policy actions are taken, will the short run Phillips curve shift to the right or upward, shift to the left and downward, or remain the same in the long run? Explain.

So pause this video again and see if you can work through that before I do that with you. The way to think about this is when aggregate output is less than full employment output, you have higher unemployment, a higher unemployment rate, and lower inflation. You have a higher unemployment rate above the natural rate, higher unemployment rate, and lower inflation. This decreases inflation expectations.

So one way to think about it is that at a given unemployment rate, you will over time have a lower inflation rate because of the lowered inflation expectations. Instead of our inflation rate being right over there, it might be right over here. For this point on our short run Phillips curve, instead of the inflation rate being there, it might be over there. It would actually shift the short run Phillips curve to the left and downwards.

Now, they're not asking us to draw that, so I don't want to do that here. I just did that to hopefully help explain the intuition, but I will just answer their question right over here. So this shifts the short run Phillips curve left/downward.

Part C: If the Federal Reserve Bank wants to lower unemployment, what expansionary open market operation should it use? So pause the video again and see if you can answer that.

Well, there are several tools that the Federal Reserve Bank can use to lower unemployment. It could change the reserve requirements for banks, but here they're explicitly talking about open market operations. The typical open market operation that the Federal Reserve Bank would do if it wants to lower unemployment is to inject more money into the economy.

It wants to increase the amount of reserves in banks, which will of course increase the money supply. To do that, they will go out into the open market and buy bonds. The Federal Reserve Bank will buy bonds. Remember, when they're buying bonds, the people who sell those bonds will take those Federal Reserve notes, deposit them in banks. That will increase the reserves of the banks. The banks will be able to lend more, and the money supply will increase.

Part D: How will the open market operation you identified in part C affect each of the following: the federal funds rate? Explain.

So, I just touched on it. We can say buying bonds will increase bank reserves, which will lead the federal funds rate to go down. The Fed funds rate will decrease. Remember, the federal funds rate is the rate at which banks borrow reserves from each other. If there's a total of more reserves now, well then there's less demand to borrow and there's more supply of reserves. So the cost of borrowing, which is the interest rate, the federal funds rate will decrease.

Real interest rates in the short run will also decrease. An increase in the money supply will lead to a decrease in nominal and real interest rates in the short run. In the short run, there is a situation where maybe you have runaway inflation—the nominal rates go down, but somehow, that doesn't affect the real rate as much. However, in the short run, we can pretty confidently say that if nominal interest rates are going down, that real interest rates will go down as well.

Then there's a last part here that is off the screen, and it says given your answer in part D, what is the effect on real Gross Domestic Product (GDP) in the short run? Explain.

Well, lower real interest rates lead to more interest-sensitive consumption and investment. When we're talking about investment, we could talk about plant and equipment, which should increase GDP, real GDP, which should increase real GDP in the short run.

In the short run, and we are done.