Assignment -

I. Philips Curve

Suppose that the Philips curve is given by

π_t = π^e_t + 0.1 -2u_t

a. What is the natural rate of unemployment?

b. Assume π_e^t = θπ_t-1

and suppose that θ is equal to 0. Suppose that the rate of unemployment is initially equal to the natural rate. In Year t, the authorities decide to bring the unemployment rate down to 3% and hold it there forever. Determine the rate of inflation in years t, t+1, t+2, and t+5.

c. Do you believe the answer given in (b)? Why or why not? (Hint: Think about how people are likely to form expectations of inflation.)

Now suppose that in year t+5, θ increases from 0 to 1. Suppose that the government is still determined to keep u at 3% forever.

d. Why might θ increase in this way? What will the inflation rate be in years t+5, t+6, and t+7.

e. Do you believe the answer given in (d)? Why or why not?

II. Open Economy

Consider an economy where

C=200+0.25(Y-T)

I = 150+0.25Y-1000i

G = 250, T = 200

(M/P)^d = 2Y-8000i

(M/P)s =1600

X = 0.3Y*, IM =0.2Y,

ε (real exchange rate) = 2, Y* is foreign output (Y* = 900)

a. Calculate the multiplier if the economy is closed and the multiplier if the economy opens up. Explain the economic intuition why two are different with 3-5 sentences.

b. Solve for the equilibrium level of income (Y) for the open economy (Y_open) and calculate the trade balance (NX).

c. Solve for the equilibrium level of interest rate for the open economy (i_open).

d. If government follows an expansionary fiscal policy and G changes by 60, calculate the change in Y for both the closed economy (?Y_closed) the open economy (?Y_open). Assume no change in the foreign output (Y*), Calculate the new trade balance.

e. If this economy has flexible exchange rate regime, how would the exchange rate respond to a fiscal expansion policy? Appreciation or Depreciation? Explain why.