1.Consider the Phillips curve _t = _t-1 - 0.5(u_t - 0.01).

a)What is the natural rate of unemployment? Graph the short-run and long-run relationships between inflation and unemployment. (5 marks)

b)How much unemployment is necessary to reduce inflation by 3%? Compute the sacrifice ratio. Show your work. (5 marks)

Do flexible exchange rates permit a country to pick its own unemployment-inflation trade-off target?