Figure 4.19: Phillips Curve and Multiplier Diagram in a Recession
This two-panel diagram illustrates the effects of a negative aggregate demand shock. The first panel shows the Phillips curve, with employment on the horizontal axis and the inflation rate on the vertical. It depicts an economy moving from its supply-side equilibrium (Point A), where unemployment is 7% and inflation matches the 3% expectation, to a recessionary point (Point C) along the same curve, characterized by higher unemployment and a lower inflation rate of 2%. The second panel shows the multiplier model, with output (Y) on the horizontal axis and aggregate demand (AD) on the vertical. The shock is represented by a downward shift of the aggregate demand curve from AD(medium) to AD(low). This moves the economy's equilibrium from Point A, at the supply-side equilibrium output (Y_SEE), to Point C, where the new AD(low) curve intersects the 45-degree line at a lower output level (Y_low).
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Figure 4.19: Phillips Curve and Multiplier Diagram in a Recession
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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.
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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?
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