The League of Big States (LBS) has in?ation expectations of 5% and an estimated natural rate of unemployment of 5%. A 2% rise (fall) in unemployment leads to a 1% fall (increase) in in?ation.
(a) What is in?ation when unemployment equals 5%?
(b) What is in?ation when unemployment falls to 3%?
(c) If unemployment falls to 3% but the Central Bank of LBS thinks that the natural rate has also fallen to 3%, what will happen to in?ation?
(d) How will the behavior of interest rates differ in your answers to (b) and (c) if the Central Bank uses higher interest rates to keep in?ation at 5%?
(e) The Central Bank is not sure whether or not the natural rate of unemployment has changed. How will its behavior vary depending upon whether its goal is (1) to achieve in?ation of 5% or less, (2) try and maintain stable in?ation and unemploy- ment, or (3) in?ation should be in the range of 4.5-5.5%?
(f) Let in?ation expectations be equal to last period's in?ation. Unemployment is cur- rently 5%, the natural rate is 5%, and last year in?ation was 5%. The Central Bank wants to lower in?ation from 5% to 2%. Compare how unemployment and in?ation vary over the next four years when
(1) the government wants to achieve 2% in?a- tion next year,
(2) the government wants to achieve 2% in?ation by lowering in?a- tion by 1% each year.