Tutorial 7 (Phillips Curve & Natural Rate of Unemployment) (Answers are provided as

a guide but not limited to the following)

1. Explain what is meant by the "wage-price" spiral effect.

Indicative answer:

The wage-price spiral refers to the effects of low unemployment on inflation. Specifically,
when the unemployment rate falls, the nominal wage will rise. As W rises, firms' costs increase
causing them to increase prices. As prices rise, workers will later ask for increases in the
nominal wage. This increase in W again causes firms' costs and prices to rise and the process
repeats itself in a cyclical manner setting off a “spiral effect”.

2. Based on the Phillips curve, explain what effect an increase in the unemployment rate
will have on the inflation rate.

Indicative answer:

An increase in unemployment will cause a fall in nominal wage. As nominal wage falls, firms'
costs fall. As firms' costs fall, they will reduce the price level. This reduction in the price level
represents, in this case, deflation (decrease in inflation) or disinflation (decrease in inflation
rate)

3. Explain how the original Phillips curve differs from the expectations-augmented
Phillips curve (or the modified, or accelerationist Phillips curve).

Indicative answer:

The original Phillips curve did not take into account the effects of changes in expected inflation.
The expectations-augmented Phillips curve did allow for changes in expected inflation to affect
actual inflation.
4. Based on your understanding of the Phillips curve, explain what happens to actual
inflation (relative to expected inflation) when the actual unemployment rate is either
above (U > Un) or below (U < Un) the natural rate of unemployment.

Indicative answer:

When the actual unemployment rate is equal to the natural rate of unemployment (U=Un), we
know that actual inflation and expected inflation must be equal. In such a case, all else fixed,
inflation will not change.

However, if the actual unemployment rate were to fall below the natural rate (U < Un), actual
inflation is higher than expected inflation, hence causing wage setter to ask for higher wages.
This causes SRPC (short run Philips curve) to shift upward. This will cause higher price setting
by firm which consequently leads to lower aggregate demand, hence aggregate supply will be
reduced. As such, unemployment will increase until it reaches Un and expected inflation =
actual inflation in the medium /long run.

So, the natural rate of unemployment rate may also be referred to the non-accelerating-inflation
rate of unemployment. (NAIRU)

If the opposite occurs ie (U>Un), actual inflation will fall below expected inflation. SRPC
(short run Phillips curve) will shift downward. This will cause lower price setting by firm which
consequently leads to higher aggregate demand, hence aggregate supply will be increased. As
such, unemployment will decrease until it reaches back to Un and expected inflation = actual
inflation in the long run. The shifting of SRPC in the short run continues until actual inflation
= expected inflation and U = Un in the long run.

In both scenarios, in long run, U = Un and actual inflation = expected inflation. Hence, when
we connect all the shifting points of SRPC where U = Un and actual inflation = expected
inflation, we formed the long run Phillips curve (LRPC) which is vertical which indicates that
there is no long run relationship between inflation and unemployment. Inflation and
unemployment inverse relationship only occurs in short run as indicated by SRPC (short run
Phillips curve).
5. Explain the NAIRU (non-accelerated inflation rate of unemployment) and its
relationship to inflation rate.

Indicative answer:

The non-accelerated inflation rate of unemployment (NAIRU) is the actual unemployment

rate at which the inflation rate remains constant. When the actual unemployment rate
exceeds the natural rate of unemployment, the inflation rate typically decreases; when the
actual unemployment rate is less than the natural unemployment, the inflation rate typically
increases.

6. Explain how changes in the proportion of wage contracts that are indexed affect
economic activity, given change in monetary policy.

Indicative answer:

Following a monetary expansion, an increase in nominal money growth will increase the
real money supply causing an increase in economic activities. As the proportion of labor
contracts that are indexed increases, the effects of changes in unemployment on inflation
would increase. A reduction in unemployment will cause an increase in inflation.

When inflation rises in a period, some contracts (those that are indexed) will call for an
immediate increase in wages further increasing inflation within that period. As indexation
becomes more prevalent, that secondary effect on inflation will be magnified. This
magnification of the inflation effect following increase in real money supply will be a
smaller and, therefore, reduce the overall output effects of a given monetary expansion.