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Question One )
The experience of the United States in the 1960s suggested that there was a trade-off between the unemployment rate and the rate of inflation. This trade-off was known as the Phillips curve, and was based on the fact that unexpected increases in prices reduced real wages, increasing the demand for labor and reducing unemployment. But any trade-off that may have existed in the 1960s disappeared from empirical data in subsequent years. Moreover, the failure of the trade-off to persist contributed to the wide acceptance of what is now known as the natural rate hypothesis.

a) Assume that the level of unemployment is rising and the government decides to take action in order to reduce the unemployment rate. Using the Philips curve analysis, discuss the steps that the government should take explaining the relation between inflation and unemployment. Use graphs to support your answer. (300 words limit) )
b) Suppose there is a rise in the price of oil which is the main input used in production. Using the Philips curve analysis, explain what would happen to the rate of unemployment and inflation in the economy. (300 words limit) )
c) Based on the data presented in the above case about inflation in USA and on Friedman’s argument that the process of trade-off between inflation and unemployment worked only on the assumption that people did not have any expectations about future inflation. Explain what would happen when the government takes a set of expansionary monetary and fiscal policy measures if we consider in the first case that people have adaptive expectations (they incorporate last year’s inflation into their expectations of next year’s inflation) and in the second case if people have rational expectations (they completely expect any changes in future inflation). Use graphs to support your arguments.

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