Consider the following Phillips curve

t = t1 0.5(u t u)

and the natural unemployment rate is given by an average of the past two years'

unemployment

u = 0.5(u t1 + u t2 )

1. What happens to the unemployment rate when the economy is in a reces-

sion? What are the long-term effects on the unemployment rate? Which

concept does the model exhibit? (3 points)

2. Why might the natural rate of unemployment depend on recent unem-

ployment? (3 points)

3. Suppose the RBA follows a policy to permanently reduce the inflation rate

by 1 percentage point (use 1, not 0.01). What effect will that policy have

on the unemployment rate over time? (7 points)

4. What is the sacrifice ratio in this economy? Explain. (4 points)

5. What do these equations imply about the short-run and long-run trade-

offs between inflation and unemployment? (3 points)