Suppose the government misjudges the natural rate of unemployment to be much lower than it is, and thus undertakes expansionary fiscal and monetary policies to try to achieve the lower rate. Use the concept of the short-run Phillips Curve to explain why these policies might at first succeed.

The Phillips Curve:

This is an L-shaped curve sloping from left to right and showing the inverse relationship between the rates of inflation and unemployment respectively.

Explanation:

From the question above, the government is seen to be trying to reduce the unemployment rate by the use of expansionary fiscal and monetary policies.

Expansionary Fiscal Policy simply means that the government will try to stimulate economic growth by reducing taxes and increasing spending.

Expansionary Monetary Policy means that the government will attempt to manipulate the discount rate, reserve requirements, open market operations, and interest on reserves in order to achieve more availability of capital to investors.

When investors "sniff" low rates, they quickly take advantage of cheap leverage for expansion, acquisition of more technologies, etc. This creates more employment, and there is a multiplier effect which in the short run translates to increased economic growth.

In the long run, however, inflation will kick back in with a vengeance. Why? consumer spending will go up. Spending power will go up. Suppliers will struggle to meet up with growing demand and when that happens, the price will generally shift in the same direction of demand (all things being equal) thus creating inflation.

When this happens, the spending power of consumers is eroded. They are back to square one. Then the government may start to try their hands on contractionary fiscal and monetary policies.

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