Suppose that natural real GDP is constant. For every 1 percent increase in the rate of inflation above its expected level, firms are willing to increase real GDP by 1 percent. The expected rate of inflation in the current period equals the actual rate of inflation in the previous period. Initially the output ratio is 100 and the actual and expected inflation rates equal 2 percent.
(a) Compute points on the short-run Phillips Curve when the inflation rate equals 0, 1, 2, 3, 4, and 5. Graph the short-run Phillips Curve.
(b) What is the growth rate of nominal GDP in the economy? Suppose that due to baby boomers becoming eligible for Medicare, there is a permanent increase in the growth rate of the federal government’s spending. That increase causes the growth rate of nominal GDP to accelerate to 4 percent.
(c) Use the short-run Phillips Curve to explain what the rate of inflation and the output ratio are in the first period after the increase in the growth rate of nominal GDP.
(d) Explain what the inflation rate is in the long run, given the increase in the growth rate of nominal GDP, and describe how the economy adjusts to the long-run equilibrium.