Economics 14.02 Problem Set 4 Due Date: 3/31/04 Please STAPLE all sheets together. Answer each as True, False or Uncertain. Give a two or three sentence explanation for your answer. 1. Indexing salaries to inflation results in a flatter Phillips Curve because part of the inflation change is absorbed within the year rather than keeping adjustment bottled-up until the following year. 2. The Phillip’s Curve shows that the natural rate of unemployment depends on the natural rate of inflation (set by long-term commitments of the Federal Reserve Board). 3. The natural unemployment rate decreased in both Europe and the United States over the last thirty years because of the competitive pressures to which globalization exposed firms. 4. The impact of output fluctuations for employment levels are diminished because some of the new workers are drawn from individuals previously classified as out-of-the-labor-force. 5. The speed at which the Federal Reserve Board undertakes dis-inflation affects the cumulative unemployment response the economy experiences.Longer Problems: 1. (Chapter 8) Please use the table below to organize your responses for parts b and e. You should show your work however so that partial credit can be given. Year T T+1 T+2 T+3 T+4 T+5 T+6 T+7 Πt Suppose the Phillips Curve is given by [Πt is the inflation rate, EΠt is the expected inflation rate, and ut is the unemployment rate]: Πt = EΠt + 0.1 – 2ut Where EΠt = θΠt-1 Also, suppose θ is initially equal to zero. a. What is the natural rate of unemployment? Suppose that the actual 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. b. Determine the inflation rate in years T, T+1, T+2, T+3, and T+4. c. How long does it take the natural rate of unemployment to decline to 3%? d. Do you believe your answer to part b? Why or why not? Think about how people are likely to form their expectations of inflation. Suppose now that in year T+5 the value of θ increases from 0 to 1. Suppose that the government is still determined to keep u at 3% forever. e. What expectations formation does θ=1 represent? Why might θ increase this way? What will be the inflation rates in years T+5, T+6, T+7? f. How does the natural rate of unemployment depend on θ? g. Do you believe the answer in e? Why or why not.2. (Chapter 9) Suppose the economy can be described by the following three equations: ut – ut-1 = -0.4*(gyt – 3%) Okun’s Law Πt - Πt-1 = - (ut – 5%) Phillip’s Curve gyt = gmt - Πt Aggregate Demand a. What is the natural rate of unemployment? b. Suppose the unemployment rate has been equal to the natural rate for the last two periods, and the inflation rate is 8%. What is the growth rate of output? What is the growth rate of the money supply? c. Suppose that the conditions are as in b), when in year T the authorities use monetary policy to reduce the inflation rate to 4% in year T and keep it there forever. What must happen to the unemployment rate in year T and thereafter? What must happen to the rate of grow of output in year T and thereafter? What must be the rate of nominal money growth in year T and thereafter? Use the following table to organize your answers. Πt ut gyt gmt Year T-1 Year T Year T+1 Year
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