Assignment

1. Suppose that the economy consists of two types of firms. Flexible price firms, who set prices P + a(Y - Y¯), and sticky price firms, who set prices E(P). Fraction s of the firm population is sticky. What will be the price level of the overall economy? Use this expression to algebraically derive a Phillips Curve style relation between inflation and output.

2. Explain a set of special circumstances that would result in a vertical Phillips curve and a set of special circumstances that would result in a horizontal Phillips curve.

3. Write down each of the five equations of the DAD-DAS model and briefly explain each in words.

4. Suppose a recession hits, spurred by a negative news shock which makes firms pessimistic about future returns to capital. Explain how the slope of the DAS curve matters for the characteristics of the recession.

5. Numerically, where do you think the natural unemployment rate is for Canada? Where do you think that people's expectations of inflations are? Take that as the equilibrium inflationunemployment point. Where is the Canadian economy now in terms of unemployment and inflation? Is this consistent with a short-run Phillips curve?

6. In terms of inflation and unemployment, characterize the 2007-2009 recession. Can this be rationalized in terms of the DAD-DAS framework?

7. Illustrate the macroeconomic reaction in response to a one-time increase in potential GDP.  Carefully show the timings of changes in inflation and output within the DAD-DAS model.