The Expectations Augmented Phillips Curve Postulates $$\Delta p = \pi - f ( u - \bar { u } ) ,$$

question 45

Essay

The expectations augmented Phillips curve postulates $$\Delta p = \pi - f ( u - \bar { u } ) ,$$
where $\Delta p$ is the actual inflation rate, $\pi$ is the expected inflation rate, and $u$ is the unemployment rate, with "-" indicating equilibrium (the NAIRU - Non-Accelerating Inflation Rate of Unemployment). Under the assumption of static expectations $\left( \pi = \Delta p _ { - 1 } \right)$ , i.e., that you expect this period's inflation rate to hold for the next period ("the sun shines today, it will shine tomorrow"), then the prediction is that inflation will accelerate if the unemployment rate is below its equilibrium level. The accompanying table below displays information on accelerating annual inflation and unemployment rate differences from the equilibrium rate (cyclical unemployment), where the latter is approximated by a five-year moving average. You think of this data as a population which you want to describe, rather than a sample from which you want to infer behavior of a larger population. The data is collected from United States quarterly data for the period $1964 : 1$ to $1995 : 4$ . Joint Distribution of Accelerating Inflation and Cyclical Unemployment, 1964:1-1995:4

$\begin{array}{|c|c|c|c|} \hline& (u-\bar{u})>0 & (u-\bar{u}) \geq 0 & \text { Total } \\& (Y=0) & (Y=1) & \\\hline \Delta p-\Delta p_{-1}>0 & 0.156 & 0.383 & 0.539 \\(X=0) & & & \\\hline \Delta p-\Delta p_{-1} \leq 0 & 0.297 & 0.164 & 0.461 \\(X=1) & & & \\\hline \text { Total } & 0.453 & 0.547 & 1.00 \\\hline\end{array}$
(a)Compute EY( )and EX( ), and interpret both numbers.