Question 1 (250 words) Suppose the economy is in a long-run equilibrium with the unemployment rate at 6% and inflation rate at 3%. (a) Draw the economy’s short-run and long-run Phillips curves. (5 marks) (b) Suppose a wave of business pessimism reduces AD. Show the effect of this shock on your diagram from part (a). If the central bank undertakes expansionary monetary policy, can it return the economy to its original inflation rate and original unemployment rate? (7 marks) (c) Now suppose the economy is back in long-run equilibrium, and then the price of imported oil rises. Show the effect of this shock with a new diagram like that in part (a). If the central bank undertakes expansionary monetary policy, can it return the economy to its original inflation rate and original unemployment rate? If the central bank undertakes contractionary monetary policy, can it return the economy to its original inflation rate and original unemployment rate? Explain why this situation differs from that in part (b). (13 marks) Question 2 (250 words) Given the unpopularity of inflation, why don’t elected leaders always support efforts to reduce inflation? (10 marks) Economists believe that countries can reduce the cost of disinflation by letting their central banks make decisions about monetary policy without interference from politicians. Why might this be so? (15 marks)
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