Problem 1. Use Okun's law to answer the questions below;

u_t - u_t-1 = -0.4(g_yt - 3%) Assuming u_t-1 = 7%

a. Compute the change in u (u_t - u_t-1) for each of the following values of g_yt: 5%, 7%, 9%. How much has output growth increased? What happens to the change in unemployment due to this increase?

b. Compute the change in u (u_t - u_t-1) for each of the following values of g_yt: 2.5%, 1.5% and 0. How much has output growth decreased? What happens to the change in unemployment due to this increase?

c.  Compute the change in u (u_t - u_t-1) when g_yt is 3%. What must the growth rate of output be to keep u_t from changing?

Problem 2. Consider a central bank decides to increase _m by 2.8%. What will be the medium run effects of this on g_yt, u_t and π_t?

Problem 3. Taxes are affected by the level of economic activity: When output increases, tax revenues typically increase, when output falls, tax revenues fall. Suppose a balanced- budget amendment is passed by Congress, which requires that the budget always be balanced. Further assume that the economy is initially operating at its natural level of output and that the budget is currently balanced.

a. Now consider consumer confidence declines. What effect will this have on the IS Curve (graph and explain), on the AD curve (graph and explain), output, tax revenues and on the budget?

b. Given that we now have a balanced- budget amendment, what will policymakers have to do in this situation?

c. Based on your answers in "a" and "b", what effect does the existence of a balanced-budget amendment have on the output effects of any shock to aggregate demand?

d. Based on your analysis in question "c", what happens to the fluctuations in output caused by shocks to aggregate demand in the presence of a balanced-budget amendment?

Problem 4. Consider B, G and T are in real terms (and in billions of dollars).

B_t-1 = 1000      G_t= 220           T_t= 200            i_t = .15    π_t = .10

a) Compute the official measure of the deficit in year t.

b) Compute the correct (i.e. inflation adjusted) measure of deficit in year t.

c) Compute the primary deficit in year t.

d) Explain what happens to the primary deficit in year t if the nominal interest rate in year t increases to 17%.

e) To what extent does the official evaluates of the deficit overstate the correct measure?

f) Given the above information, what will happen to the level of debt between years t-1 and t? Briefly Explain

Problem 5. Use the information provided in question #4 to answer this question.

a) What must happen to taxes in year t for the primary deficit to be zero?

b) What must happen to taxes in year t for the debt to remain constant between years t-1 and t?

c) What must happen to taxes in Year t for the debt to be fully repaid?