Suppose that an economy has the Phillips curve = 1 0.5(u un), and that

Question:

Suppose that an economy has the Phillips curve
π = π−1 − 0.5(u − un),
and that the natural rate of unemployment is given by an average of the past two years’ unemployment:
un = 0.5(u−1 + u−2).
a. Why might the natural rate of unemployment depend on recent unemployment (as is assumed in the above equation)?
b. Suppose that the Bank of Canada follows a policy to reduce permanently the inflation rate by 1 percentage point. What effect will that policy have on the unemployment rate over time?
c. What is the sacrifice ratio in this economy? Explain.
d. What do these equations imply about the short-run and long-run tradeoffs between inflation and unemployment?