Question ECO 583 Assignment 2 1. (a) Suppose that the economy is currently at the full

1. (a) Suppose that the economy is currently at the full employment position.
Using the AS-AD and IS-LM models explain the short run and medium
run impacts of a decrease in budget deficit. Be sure to explain
the shifts of the curves and the dynamic adjustment of the economy.
(10)
(c) Suppose that the economy is currently at the full employment position.
Using the AS-AD and IS-LM models explain the short run and medium run
impacts of a increase in money supply. Be sure to explain the shifts of
the curves and the dynamic adjustment of the economy. In this context
explain the concept of neutrality of money.
(10)
2. (a) The current inflation rate (in year 0) in an economy is 18% and the current
unemployment rate is 6%. The natural rate of unemployment is 6%, the
normal (GDP) growth rate is 3%. The coefficients for the Phillips Curve
and the Okun’s Law are ? ? 1 and ? ? 0.5 respectively. Suppose the
central bank wants to begin a process of disinflation in year 1 such that
inflation is reduced every year by 3% until it reaches the desired level of
3%. Given this desired path of inflation, calculate the paths of
unemployment, output growth rate and nominal money growth for years 1
through 7. Show and explain all your calculations and in particular, explain
why does each variable change as they do.
(32)
(b) In an economy the central bank wants to reduce the inflation rate by 9%.
Given that the coefficient of the Phillips Curve is given by ? ? 1.15,
calculate the number of point years of excess unemployment and the
sacrifice ratio. Given the goal of reducing inflation by 9%, can the central
bank affect the number of point years of excess unemployment calculated
above? Explain. Can the central bank affect the distribution of excess
unemployment over time? If so explain how. If not explain why not.
(8)
2
3. (a) An economy is described by the following equations:
AD: Y = 4000+2 (M/P)
AS: Y = Yn + 100 (P – Pe)
Okun’s Law: (Y – Yn)/Yn = -2 (u-un)
The natural rate of output, Yn = 6000, and the natural rate of
unemployment, un = .05 (or 5%).
(i) The money supply has long been constant at M = 4000. Currently, the
economy is producing the natural rate of output and it has been operating
at the level for the past few years. Calculate the current price level,
expected price and unemployment rate.
(ii) Suppose that money supply unexpectedly increases to 4488. Using the
AD-AS model calculate the short run and medium run impacts of such an
increase in money supply. In particular calculate the short run and medium
run equilibrium values of the price level, expected price, unemployment
and output.
(Hint: You may need to use the following formula to solve a quadratic
equation.
If ax2 + bx +c = 0
Then, the values of x can be calculated as
a
b b ac
x
2
4 2 ? ? ?
? .)
(22)
(b) In an economy the equation for the expectations augmented Phillips curve
is given by:
2( ) n
e ? ?? ? u ? u
Where, the natural rate of unemployment, un is 6% (or .06).
(i) Draw the graph of the Phillips curve with inflation along the vertical axis
and unemployment along the horizontal axis if the expected inflation rate
is 10% (or .10). Calculate the unemployment rate, if the Fed chooses to
keep the actual inflation rate at 10%.
(ii) Suppose that an aggregate demand shock (resulting from an increased
military spending) raises expected inflation to 12%, leaving the natural rate
of unemployment unchanged. Graph the new Phillips curve and show its
relationship to the one drawn in part (i) above. Calculate the
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unemployment rate, if the Fed chooses to keep the actual inflation rate at
10%. What happens to the unemployment rate if, after the demand shock,
the Fed announces that it will maintain the inflation rate at 10% and that
announcement is fully believed by the public?
(12)
(c) Consider a country with two political parties, Democrats and Republicans.
Democrats care more about unemployment than Republicans, and
Republicans care more about inflation than Democrats. When Democrats
are in power, they choose an inflation rate D ? and when Republicans are in
power, they choose an inflation rate R ? .We assume that D ? > R ? .
An election is about to be held. Assume that expectations about inflation for
the coming year (represented by e
t ? ) are formed before the election.
(Essentially, this assumption means that wages for the coming year are set
before the election.) Moreover, it is assumed that the Democrats and the
Republicans have equal chance of winning the election.
The Phillips curve is given by
( ) e
?t ??t ? ut ?un
where the natural rate of unemployment, n u = 6%.
(i) Calculate the expected inflation rate, e
t ? in terms of D ? and R ? .
(ii) Suppose D ? = 5.1% and R ? = 3.6%.
Suppose the Democrats win the election and implement their target
inflation rate.
Calculate the unemployment rate, t u
(iii) Suppose, instead, the Republicans win the election and implement their

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