1. True/False/Uncertain. Read the statements carefully. Decide whether the statement is true, false or uncertain. Explain your answer. Answers without an explanation will not receive credit.
a. Workers are paid their reservation wage.
b. At the medium run equilibrium, the rate of inflation is equal to the rate of nominal money growth.
c. The sacrifice ratio is equal to 1/α and indicates the number of percentage points the inflation increases for each percentage point unemployment increases by.
d. Flexible exchange rate models are more functional and preferable, relative to fixed exchange rate models.
e. The unemployment rate will rise by only a small degree if the Central Bank can quickly lower the inflation rate.
f. If the Central Bank asked Thomas Sargent and John Taylor to recommend how to achieve a lower inflation rate, both economists would easily agree on the method used to achieve a disinflation.
2. Suppose an economy in the medium run is given by the following equations:
C = 500 + 0.5Yd
I = 200 + 0.3Y - 50i
G = 200
T = 200
Ms
: (M - P) = 25 - P
Md
: YL(i) = 100Y - 100i
P = Pe
+ (Y - Yn)
Pe
= 5
Yn = 20
Note: we are taking (M - P) to be an approximation of (M/P) as this is the first-order Taylor approximation of the money supply equation. Aggregate supply is represented by P = Pe+ (Y - Yn) with the values for Pe and Yn plugged in.
a. Derive the IS curve with i as a function of Y.
b. Derive the LM curve with i as a function of Y and P.
c. Graphically derive the AD curve from the IS-LM curve. What is the economic interpretation of the AD curve?
d. When does the AD curve shift? How is a change in P represented on the AD curve? How is it represented in the IS-LM graph?
e. Derive the AD and AS curves.
f. When does the AS curve shift? How is a change in P represented on the AS curve? How is a shift in the AS curve represented in the IS-LM graph?
g. Solve for equilibrium P, Y and i.
3. Show in an IS-LM and AS-AD graph the effects of an increase in government spending. Next, using the same graph, show how the economy will transition back to the natural rate of unemployment. Explain intuitively how this transition takes place.
4. Show in an IS-LM and AS-AD graph the effects of a decrease in the price of oil. Using the same graph, illustrate the economy when it transitions to the medium-run equilibrium. What happens to the natural level of output? What happens to the price level?
5. Suppose that people expect higher future taxes due to the government's current debt levels, which causes them to start saving more now for the future tax bill. What effect will this have on the economy? Illustrate this using an IS-LM and AS-AD graph, explaining the short run effects and how the economy will transition to the medium-run equilibrium.
6. Suppose the Central Bank is currently at a medium-run equilibrium in Year 0, but wants to decrease inflation by 12 percentage points, from 16% to 4%, in 4 years. As a firm believer in the traditional approach of reducing inflation, describe the policy you would recommend by filling in the table below. To fill in the table, calculate the target path of inflation, the path of unemployment, the path of output growth and the nominal money growth assuming that α = 0.5 (from Phillips Curve) and β = 0.75 (from Okun's Law).
You should show your work or provide an explanation for how you derived the numbers in your answer. The cells have been numbered for you to aid in the reference of your work.
7. Assume the economy uses a flexible exchange rate in an open economy, and that their main trading partner's economy can be described by the following information provided in the tables. Calculate the dynamic process with which the following variables must change in order for this economy to maintain full employment, despite the fact that the two countries have chosen different inflation rates from one another. Assume workers know the Central Bank's targeted inflation rate and the goal of maintaining full employment. You should show your work to indicate how you came up with your answer.
