Let us suppose the Reserve Bank of Australia implements a disinflation policy to reduce the inflation rate from 8% to a target of 3% over a period of four years. In the first year of the policy the unemployment rate reaches 9%, in the second year the unemployment rate declines to 8%, in the third year it is 7% and then, in the fourth year, when the inflation target is reached, the unemployment rate is 5%. Supposing the natural rate of unemployment is estimated to be 5.5% over this period, how would you measure the social cost of this disinflation policy?
Question
Let us suppose the Reserve Bank of Australia implements a disinflation policy to reduce the inflation rate from 8% to a target of 3% over a period of four years. In the first year of the policy the unemployment rate reaches 9%, in the second year the unemployment rate declines to 8%, in the third year it is 7% and then, in the fourth year, when the inflation target is reached, the unemployment rate is 5%. Supposing the natural rate of unemployment is estimated to be 5.5% over this period, how would you measure the social cost of this disinflation policy?
Solution
The social cost of the disinflation policy can be measured by the excess unemployment created by the policy. This is the difference between the actual unemployment rate and the natural rate of unemployment.
Here's how to calculate it:
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First, calculate the excess unemployment for each year by subtracting the natural rate of unemployment from the actual unemployment rate.
- In the first year, the excess unemployment is 9% - 5.5% = 3.5%.
- In the second year, the excess unemployment is 8% - 5.5% = 2.5%.
- In the third year, the excess unemployment is 7% - 5.5% = 1.5%.
- In the fourth year, the excess unemployment is 5% - 5.5% = -0.5%. Since the actual unemployment rate is less than the natural rate, there is no excess unemployment in this year.
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Then, add up the excess unemployment for each year to get the total excess unemployment over the four-year period.
- The total excess unemployment is 3.5% + 2.5% + 1.5% + 0% = 7.5%.
So, the social cost of the disinflation policy, measured in terms of excess unemployment, is 7.5%. This means that the policy resulted in an unemployment rate that was 7.5 percentage points higher than the natural rate of unemployment over the four-year period.
Similar Questions
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