3. Phillips Curve (15 points) Suppose the economy has the following Phillips Curve: pi = pi^e - 2(u - u^n ) +

Assume the natural rate of unemployment is 5%, there is no supply shock, and expectations are adaptive.

3.1 Suppose that inflation over the past few years has been 4% and the economy is at its long-run equilibrium. Illustrate the Phillips Curve using the space below. You should clearly label the axes (in words and symbols), natural rate of unemployment. Label Point A as the economy's long-run equilibrium point on your diagram. Label the intercept and slope of the Phillips Curve (your graph does not need to be to scale). [3]

3.2 The central bank wants to achieve an inflation rate target of 2% in the long-run. What type of policy would they need to implement: contractionary or expansionary? Monetary or fiscal? [1]

3.3 Suppose the central bank implements the policy mentioned in #3.2 and the inflation rate falls to 3% in the short run. Using the Phillips curve equation given above, compute the unemployment rate that corresponds to this level of inflation. Label this Point B on your diagram from #3.1 [2.5]

3.4 Assume that the central bank is successful in achieving its long-run inflation target of 2%. Label the economy's long-run equilibrium assuming that the central bank implements policies needed to achieve its inflation target of 2%. Label this long-run equilibrium Point C and illustrate how the economy transitions to this point. Be sure to clearly label any new curves, intercepts and/or slopes. [2]

3.5 Based on your answers above, does the economy experience the monetary neutrality in the short run? In the long run? Explain why or why not in each case, citing your graph to support your answer. [2]

3.6 Define rational expectations and distinguish adaptive and rational expectations (in general, not on your diagram). [1.5]

3.7 On your diagram, suppose that people have rational expectations. How would this affect your analysis in #3.2-#3.5 if the policy IS NOT announced in advance? [1.5]

3.8 Now, suppose that people have rational expectations and the policy IS announced in advance. How would this affect your analysis in #3.2-#3.5? [1.5]