Question
Asked Dec 4, 2019
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Assume that inflation falls significantly below expectations. Diagram both the short-run and long-run effects on employment using a Phillips Curve diagram. What changes in this model to allow the return to longrun equilibrium?

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Expert Answer

Step 1

Assuming, that inflation falls significantly below expectations, the consequences of such a drastic fall in inflation affects the unemployment rate in the economy. The Phillips Curve depicts the relationship between inflation and the unemployment rate. The Phillips Curve is downward sloping that shows negative relationship inflation and unemployment. Therefore, if there is such a steep fall in inflation rate, it will lead to very unemployment rate in an economy. The inflation is the increase in general price levels and thus, when there is a huge fall in it. It leads to fall in prices of the goods. The producers are unable to get their due revenues and earn profit that is required. This makes them reduce their production activities and also retrenching workers, creating unemployment in the economy. This can be shown in the following diagram where Phillips Curve shows relationship between two in short run and we can see that if inflation falls below expectations, there is an increase in unemployment.

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+ Expeate d lufiatiouand uřem piey meul- lex SHORT - RUN PHILLIPS CURVE Vex UL Umemploymeni" SHORT RUN PHILLIPS CURVE

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Step 2

In long term however, the Phillips curve says there is no relationship between inflation and unemployment in the economy. The long run Phillips curve is a vertical at natural rate ...

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la Long. PhiNips urve Ruu expectad Rato Po Naliral Rate . uneimplog meut иет LONG RUN PHILIPS CURVE

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