Suppose that an economy has the Phillips curve p = p-1 - 0.5(u - u^n),
and that the natural rate of unemployment is given by an average of the past two years' unemployment:
u^n = 0.5(u-1 + u-2).
1) Why might might the natural rate of unemployment depend on recent unemployment (as is assumed in the preceding equation)?
2) Suppose that the Fed follows a policy to permanently reduce the inflation rate by 1 percentage point. What effect will that policy have one the unemployment rate over time?
3) What is the sacrifice ratio in this economy? Explain.
4) What do these equations imply about the short-run and long-run tradeoffs between inflation and unemployment?