Figure 4.19: Phillips Curve and Multiplier Diagram in a Recession

Analyzing an Economic Downturn

An economy experiences a sudden, large-scale decline in investment spending. Arrange the following events in the correct causal sequence that describes the resulting pressure on wages and prices.

An economy is initially in a stable state where the prevailing inflation rate is 4%. A sudden decrease in global demand for the country's exports causes unemployment to rise, creating a negative bargaining gap of -2.5%. Based on the direct relationship between the bargaining gap and inflation, what will be the new inflation rate in the period immediately following this shock?

In an economy experiencing a downward wage-price spiral initiated by a negative demand shock, the process is self-correcting and inflation will eventually return to its original target, even if unemployment remains persistently above its equilibrium level.

The Dynamics of a Downward Wage-Price Spiral

Explaining the Wage-Price Mechanism in a Recession

An economy experiences a significant, unexpected fall in business confidence. Match each resulting economic component to its specific role in the subsequent wage-price adjustment process.

When a negative shock to an economy's aggregate demand leads to higher unemployment, the resulting loss of worker negotiating power creates a __________, which in turn puts downward pressure on both wage and price growth.

An economy that has maintained stable 3% inflation for several years suddenly experiences a rise in unemployment. In the following period, inflation falls to 2%. If the unemployment rate remains elevated, which of the following events is the most plausible initial trigger for this economic downturn and subsequent downward pressure on wages and prices?

An economy, initially stable with 3% inflation, experiences a negative demand shock that raises unemployment and creates a persistent -1% bargaining gap. In the year immediately following the shock, inflation falls to 2%. If the high unemployment and the -1% bargaining gap persist into the second year, and economic agents now adjust their inflation expectations downwards based on the previous year's outcome, what is the most likely inflation rate in the second year?

Inflation Adjustment Equation

Downward Shift of the Phillips Curve from Updated Inflation Expectations