Assignment

I. Philips Curve: Suppose that the Philips curve is given by

πt = πet + 0.1 -2ut

a. What is the natural rate of unemployment?

b. Assume πet = θπt-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) 1

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 (Yopen) and calculate the trade balance (NX).

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

d. If government follows an expansionary fiscal policy and G changes by 60, calculate the change in Y for both the closed economy (?Yclosed) the open economy (?Yopen). 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.