In an economy the equation for the expectations augmented Phillips curve is given by: a=tº –(u-un) " " " where, the natural rate of unemployment, un is 5%. 1 1 1 (a) Draw the graph of the Phillips curve with unemployment rate and the rate of inflation measured along the horizontal and vertical axes if the expected inflation rate is 2%. Calculate the unemployment rate if the Fed chooses to maintain the actual inflation rate at 2%. Show the combination of the unemployment rate and the inflation rate on the graph. " 1 1 (b) Suppose that a demand shock (resulting from an increased military spending) raises the expected inflation to 6%, leaving the natural rate of unemployment unchanged. Graph the new Phillips curve in the same diagram as in (a) and clearly show its relationship to the one drawn in part (a) above. Calculate the unemployment rate if the Fed chooses to keep the actual inflation rate at 2%.
