ECON 20031
Problem Set 6 - Answers
1. Using the 5 equation system of Chapter 15, assume that the following information
holds for the Jamaican economy: Ȳt = 100, ρ = 2.0, α = 1.0, π ∗ = 2.0, φ = 0.5,
θπ = 0.2, and θY = 0.18. Use this information to answer the following questions.
(a) Two shocks hit the Jamaican economy simultaneously.
i. With the relaxation of the marijuana laws there’s a significant increase in
tourist arrivals. This shock to the economy has an absolute value of 6.
ii. The economy is affected by the significant fall in world oil prices. This
shock has an absolute value of 2.
You are required to categorize each shock (demand or supply) and say how
each shock enters the system. You must say whether the number for each
shock entering the system of equations is positive or negative.
Answer
An increase in tourist arrivals is a good demand shock. The absolute
number 6 enters the demand equation with a positive value. The
second shock is a good supply shock, therefore, the absolute number
2 enters the equation with a negative value.
(b) Suppose the shocks described in part a lead to an increase in actual output,
Yt = 105; i.e. actual output increases from 100 to 105. You are required to
solve for the values of rt , it , and πt .
Answer
rt = 3, it = 5.5, and πt = 2.5
To solve the system of equations you may use the following approach:
i. It’s best to start with the equation representing the demand for
goods and service. You will be able to find the value for rt .
ii. You could then solve for πt using the Phillips Curve. However,
you will have to clearly state that you are assuming that in the
previous period (t − 1), πt−1 = π ∗ . I create the problems making
this assumption so doing so will not pose a problem. Moreover,
it is a reasonable assumption to make.
iii. Alternatively you can use the fact that the Fisher equation states
that rt = it − Et πt+1 , and substitute rt for it − Et πt+1 in the mon-
etary policy equation. Note that Et πt+1 = πt . This substitution
means that the monetary policy equation would now have ONE
unknown, πt .
iv. The final step is straightforward.
(c) Based on the values for Yt and πt , which of the two shocks has the greater
impact? Your explanation must be a combination of math and economic intu-
ition, inclusive of a diagram of the AD-AS framework.
Answer
The demand shock has the greater impact. A positive demand shock
causes the AD curve to shift to the right causing upward pressure
on output and the rate of inflation. A fall in the price of oil reduces
the cost of production for “all” firms in the economy. Therefore,
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Department
c of Economics, The University of the West Indies (Mona).
1
the short run AS curve shifts outwards putting downward pressure
on the rate of inflation and upward pressure on output. Since at
the new equilibrium the rate of inflation rises, from 2 to 2.5, then
it must mean that the demand shock, which is the shock causing
upward pressure on the rate of inflation, is more powerful than the
supply shock. Both shocks put upward pressure on the level of out-
put so we cannot ascertain the size of either shock by looking at
output.