For each part of this question, please refer to one of the following concepts in your answer.
For each part of this question, please refer to one of the following concepts in your answer. • Intertemporal Substitution of Labour Supply • Total Factor Productivity • Aggregate Production Function • Policy Ineffectiveness Proposition • Lucas Critique • Stochastic vs Systematic 18 (a) (1 A4, both sides) Consider an economy where the following occurs: • In even-numbered years, the money supply does not change • In odd-numbered years, the money supply increases by 10%. Perhaps surprisingly, output does not vary from year to year, it remains constant. Unemployment does not vary from year to year, either. As for inflation: • In even-numbered years, inflation is 0% • In odd-numbered years, inflation is 10% Illustrate a graph of aggregate supply and aggregate demand to show how the observed behavior of output and unemployment occurs when the economy switches from an even-numbered year to an odd-numbered year. Explain how and why this outcome occurs. 12 (b) (1 A4, one side only) In the same economy as above, in the year t (an odd-numbered year), the money printing press catches fire, and there is no change in the money supply. However, no one notices this until the end of the year. Which of the following is the most likely rate of inflation in year t: 0%, 10%, or something between the two? Which of the following is the most likely value of output in year t: the usual level of output, more output than usual, or less output than usual? Explain why this result differs from the outcome in an even-numbered year. If it does not, why not? Page 2
For this question, consider the DAD-DAS framework of the macroeconomy. The following equations hold throughout the parts of the question. IS Curve: Yt = Y¯ + (2 − rt) + mt + t Aggregate Supply: πt = π e t + (Yt − Y¯ ) + νt Taylor Rule: it = (πt + 2) + φπ(πt − π ∗ ) + φY (Yt − Y¯ ) Fisher Equation: it = rt + π e t+1 Variable/Parameter Description Yt Output at time t Y¯ Natural level of output rt Real interest rate at time t mt Shock to the money supply t Demand shock πt Rate of inflation at time t π e t Expected inflation for time t νt Supply shock it Nominal interest rate π ∗ Inflation target (constant over time) φY Monetary policy parameter, positive φπ Monetary policy parameter, positive The variables are described in the table above. The three shock terms, mt , t , and νt , are stochastic and uncorrelated, with expected value of zero. Consider mt to be an arbitrary deviation from the intended monetary policy. 25 (a) (3 A4 sheets, both sides) Suppose initially that π e t = πt−1, so that expectations are adaptive. Solve for the equilibrium output and inflation at time t. Find the long run equilibrium output and inflation, and the long run real interest rate. Page 3 20 (b) (2 A4, front and back) Suppose initially that the Taylor rule is targeted for an inflation goal of 4%, so that π ∗ = 4. Suppose that at time t − 1, the economy is at the long run equilibrium. At time t, the central bank decides instead to target an inflation rate of 2%, so that π ∗ = 2. Complete the following table to indicate whether each of the variables increases, decreases, or stays the same relative to their values before the policy change. Yt πt rt Short Run Long Run Illustrate your answer with a graph of the DAD-DAS model. Your graph should include the old equilibrium (period t − 1), the short run (period t), and the long run (well after period t). 15 (c) (2 A4 sheets, both sides) Suppose instead that consumers have rational expectations. Consider again the change in policy from the previous part of the question, lowering the inflation target from 4% to 2%. In particular, assume that the central bank announced the policy change. Complete the following table to indicate whether each of the variables increases, decreases, or stays the same relative to their values before the policy change. Yt πt rt Short Run Long Run Illustrate your answer with a similar graph to the previous part of the question. 10 (d) (1 A4 sheet, one side) Which of the two types of expectations (adaptive or rational) yields higher output? Name one policy that the government can follow to help make expectations fit your answer (that is to say, name a policy that can help make expectations adaptive or rational, whichever was your answer). Briefly explain why.
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