Define the following terms and explain their importance to the study of macroeconomics:

Question

a. Phillips curve
b. rational expectations
c. indexing
d. stagflation

Answer 1

a. A Phillips curve is a graph depicting the rate of unemployment on the horizontal axis and the rate of inflation on the vertical axis. Phillips curves are normally downward sloping, indicating that higher inflation rates are associated with lower unemployment rates.
b. Rational expectations are forecasts that, while not necessarily correct, are the best that can be made given the available data. Rational expectations, therefore, cannot err systematically. If expectations are rational, forecasting errors are purely random numbers. If the theory of rational expectations is descriptively accurate for the economy, the government cannot alter the level of price, output, or unemployment through changes in aggregate demand unless they are unannounced.
c. Indexing refers to provisions in a law or a contract whereby monetary payments are automatically adjusted whenever a specified price index changes. Wage rates, pensions, interest payments on bonds, income taxes, and many other things can be indexed in this way, and have been. Sometimes such contractual provisions are called escalator clauses. Indexing lessens the pain of the inflation-unemployment trade-off, and therefore may result in less effort to reduce inflation.
d. Stagflation is a combination of rising inflation and increasing unemployment. This is likely to occur when there is an inward shift of the aggregate supply curve. Stagflation is not likely to occur from a shift of the aggregate demand curve alone. The stagflation of the 1970s and early 1980s was an indication of the collapse of the Phillips curve during this period.