ECONOMICS 4012
Problem Set 4
This problem explores the model from Parts II and III of my notes: OUTPUT/INFLATION
DYNAMICS. The model is:
DAD: Yt = Yt-1 + at + (mt – t)
EA-DSAS: t =  [(Yt – Yn)/Yn] + et.
In the New Keynesian case, the EA-DSAS is subject to t  0 . (Used only in II below.)
AE: e = g (t-1), where 0 < g  1.
This is simpler to use than the proper equation, and it works almost as well..
All problems use the following values:
 = 1000
Yn = 1000
 = 1.25
 = 1
g is either 0.5 (slow to adapt) or 1 (immediately adapt).
These numbers give both a demand (DAD) and supply (DSAS) inflation-elasticity of unity, so things
happen fairly quickly.
To do these exercises, use the algorithm on page 12 of the notes.
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Do each of the below twice, once with g = 0.5, once with g = 1. For each find Yt , t and et for t =1,3.
Draw crude graphs for each exercise.
I.
Y0 = 1000
0 = 0
A. Expansionary fiscal policy:
a1 = 80;
a2 = a3 = 0
1. No accommodation: mt = 0
2. Lagged accommodation: mt = t-1
3. Instant accommodation: mt = t (This is a bit weird, but see what happens.)
B. Supply shock:
1 = .10;
1. No accommodation: mt = 0
2. Lagged accommodation: mt = t-1
3. Instant accommodation: mt = t
II.
a1 = a2 = a3 = 0
Disinflation: Y0 = 1000
0 = .10
e0 =.10
Do 1. and 2. twice; a) with Flexible Prices, b) New Keynesian.
1. Cold Turkey: mt = 0
2. Gradualism: mt = .5t-1
3. Do nothing: mt = t-1
This is due at the beginning of class Tuesday, November 21.
a1 = a2 = a3 = 0