Ave Maria University
Fall 2005
Intermediate Macroeconomics
ECO 301
Test Two
Due on
Saturday,
October 8, 2005
5pm
Answer Key
•
There are 6 parts to this exam, in 9 pages, for 106 total points.
•
Attempt to answer all questions. Partial credit will be given.
o Unanswered questions will not receive any credit.
o Whenever appropriate, justify your answers.
•
Read each question carefully. Make sure you understand it before answering.
•
If you don’t type, write clearly, neatly, legibly.
Read each question carefully.
Part I. Multiple-Choice Concept Questions (4 points each, 16 total)
1) Consider the wage-setting and price-setting equations we studied in
class. Suppose the markup, m, equals 0.25, and F(u,z) = 1-u. What is the
natural rate of unemployment in this economy?
A) 0.2
B) 0
C) 0.25
D) 0.1
E) 0.5
2) In the medium-run/long-run, a decrease in the budget deficit will produce:
A) No effect
B) An increase in investment
C) An increase in the money supply
D) A decrease in output
E) No effect on the price level
3) Suppose that workers in the Republic of Communia are highly unionized, while workers in the Republic of Individuela are not. In all other
respects, the two countries are exactly the same. Which statement is true
(given our model in chapter 6)?
A) Communia is likely to have a higher natural level of output than Individuela.
B) Communia is likely to have a higher natural rate of unemployment
than Individuela.
Read each question carefully.
C) Real wages are probably lower in Communia than in Individuela.
D) In the short-run, the price level is always lower in Communia than in
Individuela.
E) In the short-run, output is always higher in Communia than in Individuela.
e
4) Suppose the Phillips curve is given by π t = π t + 0.1 − 3u t , where
π te = θπ t −1 . Assume that only for the first two periods (t=1 and t=2) peo-
ple form their expectations using θ=0. From t=3 on, they start using θ=1
forever. Assume that the government still wants to keep unemployment
at 2%. What is the expected rate of inflation for t=4?
A) 2%
B) 4%
C) 8%
D) 12%
E) 16%
Read each question carefully.
Part II. True/False/Uncertain Questions (3 points each, 15 total)
Decide whether each statement is true or false and justify your answer with a
short argument. There are no points for just guessing if the answer is true, false
or uncertain.
1. An increase in the markup (m) will tend to reduce unemployment.
False. For given nominal wages, a higher markup will tend to raise prices [because the PS relation is P=(1+µ)W]. This means a shift of the PS curve and a
movement along the WS curve. Workers will only accept lower wages if their
bargaining power is reduced … by higher unemployment. So the natural rate
of unemployment (found at the intersection between the PS and the WS
curves) must be higher.
W
P
1/(1+µ)
1/(1+µ')
u
2. The natural rate of unemployment is unchangeable because all of its determinants are exogenous.
False. The determinants of the natural rate of unemployment are exogenous
(markups, bargaining power, unemployment insurance, etc.), but they certainly can change, and policy can make them change.
3. When output is below the natural level of output, the actual price level is
lower than the expected price level.
True. The actual price level equals the expected price level when output is
equal to the natural level of output. Because the AS curve is upward-sloping, if
output is below its natural level, the actual price level is lower than expected.
4. Suppose neither consumption nor investment are affected by the interest
rate. (Draw an IS-LM graph that shows this, and show how that graph is
related to the AD-AS graph). Then monetary policy will be more effective
in changing output in the short-run that if C and I depended negatively on
the interest rate. (Draw, in IS-LM, an expansionary monetary policy.
Read each question carefully.
Draw the effects of this on the AD curve.). The reason is that there will be
no “crowding out” and AD will shift by a lot. Explain beside the graphs.
i
LM’’
LM’ LM
False. If neither C nor I are
affected by investment, the IS
curve will be vertical because
IS
any interest rate will be consistent with a pre-determined level
of output). This will make the
Y
AD curve also vertical, because
P
AS
any level of prices will be consistent with that exogenouslyAD
determined output. For the
same reason, monetary policy
will be ineffective.
Y
5. In terms of changing output, monetary policy is relatively more effective
when the AS curve is relatively flat, while fiscal policy is more effective
when the AS curve is relatively steep. (Draw IS-LM and AD-AS graphs
that show whether this is true or not. Explain in the next page).
i
LM
i
IS
LM
IS
Y
Y
P
AS
P
AS
AD
AD
Y
Y
False. The relative effectiveness of monetary versus fiscal policy is not affected by the shape of the AS curve.
Read each question carefully.
6. Suppose there is a decrease in the price level from P to P’. Given the stock
of nominal money, M, this leads to an increase in the real money stock,
M/P, which shifts the LM curve down. This implies that the AD curve
shifts to the right. (Draw IS-LM and AD-AS graphs that show whether
this is true or not. Explain beside the graphs).
i
LM
LM’
IS
Y
P
AS
False. The decrease in prices
was caused by either a shift of
the AS or of the AD curves. In
any case, a change in prices
(which does shift the LM curve
down) would cause a movement
along the AD curve, not a shift.
AD
Y
7. The neutrality of money means that monetary policy cannot affect output
at any point in time.
False. It is true that in the medium run, the increase in nominal money is reflected entirely in a proportional increase in the price level, and therefore the
increase in nominal money has no effect on output or on the interest rate.
However, the neutrality of money in the medium run does not mean that
monetary policy cannot or should not be used to affect output: a monetary expansion can, for instance, help the economy move out of a recession and return
faster to the natural level of output. In fact, in the short run, an increase in the
money supply leads to an increase in output, an increase in the price level, and
a decrease in the interest rate. What the term implies is that monetary policy
cannot sustain higher output forever. (See page 147.)
8. An oil shock will have no effect on budget deficits.
False. An oil shock affects the markup level (µ) and then the natural unemployment rate (un) and the natural output level (Yn). The output level is affected both in the short run and in the medium run. If tax revenues are proportional to output (T=tY), the revenues are going to be affected and therefore the
Budget Deficit (BD=G-T=G-tY).
Part III. Aggregate Demand and Aggregate Supply question. (24 points total)
Read each question carefully.
Price Setting Relation:
Wage Setting Relation:
Goods Market:
Financial Market:
W = Pe F (u,z)
P = (1 + m ) W
Y = C(Y, T) + I(Y, i) + G
s
d
M = M (Y, i ) P
1. Find the aggregate supply relation. Describe the channel through which
the AS curve slopes up/down. (3 points)
Putting together the price setting relation and the wage setting relation,
P = Pe (1 + m) F (u,z)
AS: P = Pe (1 + m) F ([1-Y/L], z)
The AS curve slopes up. (There is a positive relationship between P and Y.)
Why? Let us start at a point on the AS curve. Now, if we were to increase Y,
then u decreases since u = 1-Y/L. A decrease in u would increase W, because
with a lower unemployment rate, people demand higher wages. Because W
is part of the input cost for firms, when W increases, P increases. Therefore,
there is a positive relationship between Y and P.
2. Assume that the economy is at a point such that the unemployment rate is
equal to the natural rate of unemployment. What does this imply about
the price level and output? Explain why. (5 points)
When P = Pe, making the price setting and wage setting relation equal to
each other gives us uN (natural rate of unemployment).
In other words, if u = uN, then P = Pe .
P = Pe (1 + m) F (u,z)
1 = (1 + m) F (un,z)
1/(1 + m) = F (un,z)
If Y = N, then u = 1 – (Y/L).
Therefore, if u = uN, then Y = YN. That is, if unemployment rate is equal to
the natural rate of unemployment, then output is equal to the natural level
of output.
The three conditions (u = uN, Y = YN, and P = Pe) give us the same information; the economy is at the medium-run/long-run equilibrium.
3. What will happen to the AD relation in the short run if there’s a monetary
contraction? What happens in the short-run and the medium-run/longrun? Start from point A where P = Pe. (3 points)
In the short run, the AD relation will shift to the left if there is a monetary
contraction.
Read each question carefully.
LMSR
i
LM0
=LMMR
B
A=C
ISMR =ISSR =IS0
Y
P
Pe
A
AS0=ASSR
ASMR
B
PeNEW
YSR
C
AD0
ADMR =ADSR
YN
Y
A monetary contraction shifts the
LM curve to the left in the short
run. This also shifts the AD
curve to the left, since equilibrium output has fallen at any level
of prices.
(In AD-AS equilibrium, prices
fall slightly as output falls in the
short run because AS is upward
sloping. So I should have drawn
the short-run LM a little more to
the right).
In the medium run, since the natural level of output hasn’t changed,
the economy returns to YN as expected prices fall and the AS
curve shifts down. The fall in
prices shifts the LM curve to the
right, back to the original place.
This is just a movement along the
new AD curve, however.
Draw an IS-LM graph and an AS-AD graph, labeling the following:
a. The original IS0, short-run ISSR, medium-run ISMR,
the original LM0, short-run LMSR, medium-run LMMR,
the original AD0, short-run ADSR, medium-run ADMR,
the original AS0, short-run ASSR, medium-run ASMR;
b. the short-run equilibrium as point B, the medium-run/long-run
equilibrium as point C; and
c. output associated with natural rate of unemployment.
4. If the price of oil increases sharply, what happens in the short-run and the
medium-run/long-run? Start from point A where P = Pe. (10 points)
Draw an IS-LM graph and an AS-AD graph, labeling the following:
a. The original IS0, short-run ISSR, medium-run ISMR,
the original LM0, short-run LMSR, medium-run LMMR,
the original AD0, short-run ADSR, medium-run ADMR,
the original AS0, short-run ASSR, medium-run ASMR;
Read each question carefully.
b. the short-run equilibrium as point B, the medium-run/long-run
equilibrium as point C; and
c. output associated with natural rate of unemployment.
(draw the graphs on the next page)
5. Indicate, from your graphs, whether these variables increase, decrease or
remain the same when the price of oil rises sharply. (You may use arrows.) (3 points)
shortrun
mediumrun
Y
Yn
P
i
I
Decreases
Decreases
Increases
Increases
Decreases
Decreases
Same as
SR
increases
Increases
Decreases increases
Read each question carefully.
Pe
No
change
i
LMMR
LMSR
LM0
ISMR =ISSR =IS0
Y
ASMR
ASSR
P
PeNEW
AS0
Pe
ADMR =ADSR =AD0
YNNew
Higher oil prices lead to a decrease in the natural level of output.
Because the AS curve goes
through the point where P=Pe and
Y=YN, and because in the short
run Pe is fixed but YN has now
decreased, there’s a shift up of the
AS curve in the short run, causing
an increase in prices and a decrease in output.
Higher prices lower M/P, so the
LM curve must shift up in the
Short Run.
In the medium run Pe rises so that
AS and AS intersect at YN.
This implies an even larger fall in
LM.
Y
YN
Part III. Analytical Aggregate Demand and Aggregate Supply Question (18
points total)
In the first test, you found that in the Republic of Keynesia the IS relation is given
by
Y=
Let
c 0 + b0 + G
b1
i
−
1 − c1 (1 − t ) 1 − c1 (1 − t )
1
= λ for simplicity. Now we can rewrite the IS curve as
1 − c1 (1 − t )
Y = λ (c0 + b0 + G − b1i )
You also found that the LM relation is given by
i=
1
m2
⎛
MS
⎜⎜ m0 −
P
⎝
⎞ m1
⎟⎟ +
Y
⎠ m2
Read each question carefully.
1. Derive the expression for aggregate demand using the above equations. Is the
AD curve upward- or downward-sloping? (5 points)
m
m
MS
− λb1 1 Y
Y = λ (c0 + b0 + G ) − λb1 0 + λb1
m2
m2 P
m2
Y + λb1
m
m1
MS
Y = λ (c0 + b0 + G ) − λb1 0 + λb1
m2
m2
m2 P
⎡
m0
m1 ⎤
MS
+ λb1
Y ⎢1 + λb1
⎥ = λ (c0 + b0 + G ) − λb1
m2
m2 P
m2 ⎦
⎣
⎡ m + λb1m1 ⎤
m0
MS
(
)
Y⎢ 2
c
b
G
b
b
λ
λ
λ
=
+
+
−
+
0
0
1
1
⎥
m2 P
m2
m2
⎣
⎦
S
⎡ λ m2
⎤
(⎥ c0 + b0 + G ) − ⎡⎢ λb1 ⎤⎥ ⎡⎢m0 + M ⎤⎥
Y =⎢
P ⎦
⎣ m2 + λb1m1 ⎦
⎣ m2 + λb1m1 ⎦ ⎣
The AD curve is downward-sloping in the (Y,P) space.
⎡
dY ⎢
1
=⎢
m
dP ⎢
1 + b1 1
⎢⎣
λ m2
⎤
⎥ bMS
1
⎥
>0
2
⎥ λm2 ( − P )
⎥⎦
Intuitively, for an increase in the price level, there is a decrease in the real
money stock, which leads to an increase in the interest rate. The increase
in the interest rate causes a decrease in the demand for goods, which leads
to a decrease in output. This implies that the relation between output and
price is negative, which is exactly what the AD curve captures. (See page
139.)
2. Show that because of the sizes and the signs of the parameters, an increase in
M/P or G will increase output. If you know calculus, use it to prove it
mathematically. (5 points)
⎤
⎡
⎥ b
⎢
dY
1
⎥ 1 >0
=⎢
m λ m2 P
dM ⎢
1 + b1 1 ⎥
⎢⎣
λm2 ⎥⎦
⎤
⎡
⎥1
⎢
dY
1
⎥ >0
=⎢
m1 ⎥ λ
dG ⎢
1 + b1
⎢⎣
λm2 ⎥⎦
Read each question carefully.
The first equation says that output is an increasing function of the Money
stock. When the real money stock decreases, the interest rate increases in order to clear the financial market (through the LM equation). We know this because m2 is positive, and MS is preceded by a minus sign in the LM equation.
Since the interest rate increases, investment and output decrease (in the IS
equation). We know this because b1 and lambda are positive, and i is preceded
by a minus sign in the IS equation. The two minus signs cancel out as we derive the AD equation.
The second equation says that output is an increasing function of G. A higher
G increases output through the multiplier (which is lambda and is positive).
Notice that this positive effect is reduced by the term within the brackets,
which represents the positive effect of G on interest rates and the negative effect of higher interest rates on investment.
3. Let:
c0 = 200
c1 = 0.5
b0 = 300
b1 = 0.4
m0 = 400
m1 = 1
m2 = 0.8
S
M = 200
G =100
t=0
Yn=550
Calculate the AD equation using these figures. (All figures are in millions of
US dollars.) (3 points)
λ=
1
=2
1 − c1 (1 − t )
0.8 * 2
0.4 * 2
200
(200 + 300 + 100) −
(400 −
)
0.8 + 2 * 0.4 *1
0.8 + 2 * 0.4 *1
P
1.6
0.8
200
(200 + 300 + 100) −
(400 −
)
Y=
1.6
1.6
P
200
)
Y = (200 + 300 + 100) − 0.5(400 −
P
100
100
(or P =
Y = 400 +
)
P
Y − 400
Y=
4. Suppose the aggregate supply takes the following form:
P = P e + (1 / 50)(Y − Yn )
Read each question carefully.
Assume P=1. Assume we are in the short-run for now. What is the numerical value of equilibrium output, Y*? What is the numerical value of the expected price level, Pe? Draw the corresponding AS-AD diagram. (5 points)
The fact that P=1 implies that we are at short-run equilibrium, so we can
just plug that into the AD equation to get Y*=500.
Using the fact, given above, that Yn = 550, 1 = Pe+1/50(500-550)
1 = Pe – 1.
Then Pe = 2.
P
AS
Pe
P
AD
Y*
Yn
Y
Read each question carefully.
5. The Keynesian government is up for reelection soon, and so it wants to
achieve the natural level of output. (We are still in the short run.) Propose
the appropriate fiscal policy. Draw the IS-LM and the AS-AD diagrams,
and show how changes in the first graph translate into the second. Calculate by how much the government must increase/decrease government
spending to achieve the new natural level of output. (5 points)
i
LM
IS
Y
P
AS
Pe
P
AD’
Y*
Yn
AD
Y = (200 + 300 + 150) − 0.5(400 −
Y = 450 +
100
(or
P
P=
Y
200
)
P
100
)
Y − 400
If P = 1
Y = 550 = Yn
Notice that here there’s no “multiplier” effect: an increase of 50 in G increased Y by 50. The reason is that the “crowding out” effect of G on i and I
is strong enough to counteract it.
Read each question carefully.
6. The Keynesian government decides not to listen to you, and raises government spending by more than would be required to achieve the natural
level of output. Their argument is that higher output is better. The voters
apparently think so too, and the government gets reelected. What happens
as time passes and we get to the “medium run”? (You do not have to do
any calculations, just draw diagrams and give some intuition.) (5 points)
i
LM
IS
Y
P
P’
Pe
AS
P
By raising Y above Yn, the
Keynesian government causes
the economy to overheat. As
expected prices rise, the AS
curve shifts up, raising prices
and bringing output back to
natural output.
AD’
Y* Yn
AD
Y
Read each question carefully.
Part V. The Phillips Curve (4 points each, 16 total)
Suppose the Phillips curve is given by
π t = π te + 0.2 − 5u t ,
where π te = θπ t −1
1. What numerical value for the natural rate of unemployment in this economy?
The natural rate of unemployment is defined as the rate of unemployment
when the actual price equals the expected price, Pt = Pte , or alternatively, πte
= πte. Therefore, we have 0=0.2 - 5un. So, un=4%.
2. For now assume that θ=0. What does this mean?
This means that agents in the economy ignore past inflation and assume that
this year’s price level is roughly the same as last year’s price level. This is a
reasonable assumption as long as inflation is low and not very persistent. (See
page 167.)
If ut = un, inflation is equal to ____0_____(in period “t-1”).
3. With θ=0, suppose that (in period “t”)the government decides to lower unemployment to 3% and keep it there forever. What is the rate of inflation for t,
t+1, t+2, t+3, …? Is this realistic? Why?
Year
t–1
t
t+1
t+2
πt
0%
5%
5%
5%
u
3%
3%
3%
3%
This is not a very realistic model. Inflation
expectations are zero in every period, but
actual inflation is 5%. This means that
every period people underestimate the rate
of inflation. It would be more realistic if
expectations changed, depending on what
the actual inflation rate is.
4. Assume that only for the first three periods (t, t+1, and t+2) people form their
expectations using θ=0. After the third period, from t+3 on, they start using
θ=1 forever. Also, the government still wants to keep unemployment at 3%.
What is the rate of inflation for t = 4, 5, and 6? What is the expected rate of inflation for t+4, and t+5? Is this setup more realistic? Why?
Year
t+3
t+4
t+5
t+6
πt
u
3%
3%
3%
3%
10%
15%
20%
25%
This is a more realistic setup, because expectations adapt to inflation behavior. For
example, in period 4, people expect inflation to be 0.05, but it is actually 0.1. So, for
the next period, people adjust their expectations to be 0.1. However, inflation expectations are always lagging behind actual
inflation, and people are still constantly
underestimating inflation.
Read each question carefully.
Part VI. Analytical Questions on Inflation, Unemployment, and Economic Activity in the Medium Run (22 point total)
Suppose an economy that can be described by the following set of equations.
(1)
(2)
ut − ut −1 = − β(gyt − g y )
gyt = gmt −πt
(3)
πt −πt = −α(ut − un )
e
6 points
1. The name of equation (1) is _____Okun’s Law ___________________________ .
Describe in words what it means
This equation recognizes the fact that productivity of labor (A) and the labor force itself (L) are growing at the combined rate of gy (normal growth
rate). So unemployment rate decreases every time output growth rate is
above the normal rate. The relation is derived from the production function Y=AN so u = 1-Y/AL.
The exogenous variables in this equation are the normal growth rate, the actual growth rate, and the β parameter (but the actual growth rate is derived
from the AD relation).
The endogenous variables are the change in the rate of unemployment.
2. The name of equation (2) is AD-relation.
Describe in words what it means. This equation states that increasing the
real amount of money increases the level of output in equilibrium. The
above equation is describing that relation in rate of growth terms, assuming
the relation between the equilibrium output level and the real amount of
money is linear (Y=γM/P). This equation is derived from the IS-LM model,
where equilibrium output increases when the real money stock increases.
The exogenous variables in this equation are the money growth rate, given
by policy, and the inflation rate, given by the Phillips curve..
The endogenous variables are the growth rate of output. ________________ .
3. The name of equation (3) is Phillips curve.
Describe in words what it means It states the fact a decrease in unemployment leads to higher wages and then prices.
The exogenous variables in this equation are the actual rate of unemployment (derived from Okun’s Law), the natural unemployment rate (derived
from wage bargaining, markup, the production function, etc.), and the parameter α. __________________________________________________________ .
The endogenous variables are the change in the inflation rate.
Read each question carefully.
16 points
2. a. (2 points) By how much does inflation differ from expected inflation in the
medium run?
Expected inflation and actual inflation are equal in the medium run.
This means that, in the medium run, ut = un.
Given your answer, rewrite equation 3 (simplify as much as possible).
ut = un
b. (3 points) In the medium run, ut - ut-1 = _0__. What does this imply for the
medium-run value of gyt? It will be equal to gy-bar.
Rewrite equation 2 using your answer. g yt = g y
(Assume a constant gmt). This means that, in the medium run, πt =
g mt − g y
c. (2 points) Using your answers to (a) and (b), represent this (medium-run)
equilibrium graphically in (π, u) space by plotting the rewritten equations 2
and 3.
πt
un
g mt − g y
ut
un
d. (4 points) Suppose the “normal growth rate” increases. Using the rewritten equation 2, what does this do to medium-run inflation? Inflation
falls.
What does it do to medium-run unemployment? Nothing.
Read each question carefully.
Show the effect of an increase in the “normal growth rate” on the medium
term equilibrium graphically.
πt
un
g mt − g y
g mt − g y '
e.
un
ut
(3 points) Give economic intuition for your result. Why does a change in
the normal growth rate have this effect on medium-term inflation?
Putting the math in words: If the normal rate of output growth increases, adjusted money growth falls and so inflation falls. The short-run process is this:
higher normal output growth (assuming actual growth is unchanged for the
moment) leads to rising unemployment (because the normal-actual gap is now
positive). Rising unemployment, by the Phillips Curve, lowers inflation.
Lower inflation, at the same rate of nominal money growth, raises actual output growth, until the normal-actual gap is closed and unemployment goes
back to natural.
What is the economic intuition? If there’s more stuff, but the same amount of
money, prices should fall. If “stuff” is being produced more quickly, but the
Fed is printing money at the same rate, prices should rise less quickly (inflation should fall). In other words (that is, going back to “math in words”), if
the normal rate of output growth increases, adjusted money growth falls and
so inflation falls. :-)
f. (2 points) What does the “medium term” equilibrium teach us about the
causes of inflation? What is the relation between inflation and monetary
policy?
The causes of inflation in the medium run are purely monetary. Inflation is
equal to the excess of nominal money supply growth over output growth. Intuitively, money demand and output are proportional, so an increase in the
normal output growth rate is an increase in the real money demand. Keeping
the growth rate of nominal money constant, the equilibrium is attained with a
lower growth rate of prices.
Read each question carefully.
21 points
3. a. (4 point) Does π differ from πe in the short run?
Plot the short-run equation 3.
On the graph, identify the intercept of the line and its slope.
On the graph, identify the point where π = πe and u = un.
πt
πe
(un, πe)
ut
un
b. (4 point) Solve (short-run) equation 1 for gyt and plug it into equation 2.
g yt = g y − (1 β )(ut − ut −1 )
g mt − π t = g y − (1 β )(ut − ut −1 )
Solve the result for πt.
π t = g mt − [g y − (1 β )(ut − ut −1 )]
π t = [g mt − g y − ut −1 β ]+ (1 β )(ut )
Plot this equation below. The slope of the line is__ 1/β ____________.
[
]
and its intercept is___ g mt − g y − ut −1 β _________.
πt
ut
c. (3 points) Assume that the intersection of the two lines that you drew
above represents a the medium-term equilibrium for the economy at time
at time t. Suppose that in period t+1 there is a fall in money growth, from
gm1 to gm2. On the next page, draw both curves together and show, on the
curves you have plotted, what is the short-term effect of the fall in gmt.
Read each question carefully.
πt
Okun’s Law + Aggregate Demand
Phillips Curve
ut
Make sure to label the curves!
un
d. (4 points) In the graph above, show and explain what will happen as the
economy goes back to medium term equilibrium. Explain why below.
πt
Okun’s Law + AD
If u > un, workers lose bargaining
power, so they demand smaller
raises and prices rise by less. This
lowers inflation until u = un.
Phillips Curve
ut
Make sure to label the curves!
un
e. (4 points) Suppose the central bank had an extremely high degree of
credibility among the private agents of the economy. It is so trustworthy,
expectations of inflation adjust at the same time as the reduction in gmt is
carried out.
In the space below, redraw the two curves you drew above and show, on
the curves you have plotted, what is the short-term effect of change in πe
that accompanies a completely credible fall in gmt.
πt
Okun’s Law + AD
Phillips Curve
ut
un
Read each question carefully.
Make sure to label the curves!
How does your answer to part (d) change?
If disinflation is credible, inflation expectations fall on impact, lowering inflation also on impact.
f. (2 points) Over time, what happened to nominal money growth?
It fell.
What happened to real money growth?
At first it fell, but then it went back to the original rate.
Why are these two different?
Because inflation fell.
Read each question carefully.
Part VII. Disinflation (11 points total)
1. (2 points) What is the “sacrifice ratio”?
The sacrifice ratio accounts for the cost of a disinflationary policy in terms of
unemployment. It is the number of point years of excess unemployment that
an economy has to suffer in order to achieve a one-percentage point decrease
in inflation.
If individuals form expectations about future inflation based on previous
year’s inflation rate, this ratio is equivalent to the inverse of the slope of the
Phillip Curve (1/α).
In this case, the sacrifice ratio is not affected by the degree of gradualism of
the disinflationary policy, since the number of point years of excess of unemployment is not affected. So, policy makers can choose between a gradual disinflationary policy that involves a lower excess unemployment rates for a long
time or a high excess of unemployment for a short period of time.
2. (3 points) Would the sacrifice ratio change if the central bank had a high degree of credibility among the private agents of the economy? Explain.
If the Central Bank had a high degree of credibility, the announcement of a
disinflationary policy might induce lower expected inflation rate. In the extreme case where individuals form their expectations according to the CB’s inflation target, the transition towards the new medium run equilibrium is instantaneous (in question 3, the economy jumps from equilibrium A to B)
without suffering from excess of unemployment. In this extreme case, the sacrifice ratio is zero.
3. (3 points) How did the U.S. Federal Reserve convince US economic agents
that it was very much against inflation? Do you think the cost of acquiring
high credibility was worth the price?
Many people have explained the low-inflation, high-growth 1990s by arguing
that the Fed was so clearly against inflation that if inflation every reared up its
head, it would be shot down immediately by high interest rates and a recession. No one likes high interest rates and recession, so no one raised prices
much. The Fed acquired its reputation, as recounted in chapter 9, by creating a
deep recession in the early 1980s. It proved to agents that it was willing to do
whatever it took -- including really high rates of unemployment for a long
time -- to keep inflation low, so agents came to believe that the Fed would do
so again in the future. Very high unemployment was the price for an antiinflation reputation. Is high unemployment (which leads to homelessness,
discouraged workers, crime, etc.) a worthwhile price for stable prices?
Read each question carefully.