1) at Point B, What Is the Rate of Inflation, Unemployment Rate, and How Much Inflation

1) At point B, what is the rate of inflation, unemployment rate, and how much inflation do people expect?

Answer: Inflation is a little more than 8% (just above the halfway point of 6% and 10%). Unemployment rate is just under 4%. Expected Inflation is 6% because point B is on the 6% Expected Inflation curve.

Consider the following actions of the Fed and predict what the unemployment rate will be. In the next three cases (2-4), the Fed follows laissez faire, and people always expect inflation to be about 2%:

2) The Fed delivers on the expect 2% inflation.

3) The Fed loosens up the money supply and inflation rises to 5%

4) The Fed decreases the inflation rate to zero.

Answer: Since Questions 2, 3, and 4 have people expecting inflation to be 2%, then we’ll use only the 2% Expected Inflation Curve.

The answer for 2) is at point Q2. Q2 is found by using the 2% ExpInf line and making sure inflation is at 2% on the vertical axis. The Unemployment rate at Q2 is the natural rate which is 5% in this worksheet (which is on the low end of what the US natural rate might be, 5% to 6%).

The answer for 3) is at point Q3. Q3 is found by using the 2% ExpInfl line and making sure inflation is at 5% on the vertical axis (You have to approximate where 5% is. Halfway between 2 and 6 is 4. Then if you go halfway from 4 to 6, you can approximate 5%). The unemployment rate at Q3 is about 3% (looks really close to 3%, might be just a little over it).

The answer for 4) is at point Q4. Q3 is found by using the 2% ExpInfl line and making sure inflation is at 0% on the vertical axis. The unemployment rate at Q4 is about 6.5%. Halfway is 7%, and Q4 looks to be about in the middle of 6% and the 7% mark.

5) Fed becomes an activist. People, still accustom to 2% inflation, don't anticipate the Fed's new 6% inflationary policy.

6) After seeing the new 6% inflation, people now expect it. The Fed maintains the 6% inflation. How successful is monetary policy now?

Answers:

5) Use the 2% ExpInf curve (people are still accustom to 2% inflation. Make sure actual inflation is at 6% on the vertical axis. That puts the economy at point Q5. The unemployment rate is approximately 2.7% (a little less than the halfway point of 3%).

6) Since people change their expectations, we need to use the 6% ExpInf curve instead. Inflation is still at 6% on the vertical axis. So the economy is at point Q6. The unemployment rate is at the natural rate.

7) The Fed increases inflation to 10%, but people anticipated the inflation change. How successful is the Fed’s new higher inflation policy?

8) The Fed says they are going to cut inflation from 10% to 6%. No one believes them, and the Fed does not cut inflation. How would people view future statements by the Fed?

9) The Fed says they are going to reduce inflation to 6%, no one believes them, but the Fed does reduce inflation.

10) The Fed maintains the 6% inflation rate, and people now expect it.

Answers:

7) Use the 10% ExpInf curve (people expect the new higher inflation rate). Inflation is at 10% on the vertical axis. That puts the economy at point Q7. The rate of unemployment will be the natural rate. The Fed’s higher inflation policy is completely ineffective. In question 6, the unemployment rate was at the natural rate and it’s still at the natural rate. Raising inflation did not reduce unemployment.

8) People expect 10% inflation and inflation is kept at 10%, so we’re at the same point as 7). People would view future statements by the Fed very skeptically. This creates the idea of “credible” policies – that is policies that people believe will be carried out.

9) Use the 10% ExpInf curve (people don’t believe the Fed will reduce inflation) but make inflation 6% on the vertical axis. That puts the economy at point Q9 with an unemployment rate of about 8.5%

10) Actual inflation equals expected inflation so the economy returns to the natural rate of unemployment.

11) Assume inflation is running at 2%. The Fed increases inflation to 6%. What happens to unemployment if: people don’t expect the increase? People expect the 6% rate? People expect 10% inflation? So what can be said about the effects of the Fed increasing the money supply and inflation?

Answers:

The Fed increases inflation from 2% to 6%.

If people don’t expect the increase, we end up at point Q5 (inflation is 6% on the vertical axis but people expect 2% so we use the 2% ExpInf curve). Unemployment rate is 2.7%

If people expect the increase, we end up at point Q6 (inflation is at 6% and people expect 6%). Unemployment rate is at the natural rate of 5%.

If people expect an even higher rate of inflation, 10%, then we end up at point Q9 (inflation is at 6% on the vertical axis but people expect 10% so we use the 10% ExpInf curve). Unemployment rate is 8.5%.

So if the Fed increases the inflation rate from 2% to 6%, the effect on unemployment could be lower unemployment (such as 2.7%), the same rate of unemployment (natural rate), or an even higher rate of unemployment (such as 8.5%). It depends upon what people think might happen.

What happens if the Fed injects money faster and increases inflation? It depends.