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Problem Set 5 Answers

This document contains sample answers to problems from an economics problem set. It addresses: 1) Solving a 5 equation model for long-run values and the impact of a change in full employment output. 2) Using the model to analyze the impact of a recession in other countries reducing tourism to Jamaica, representing a demand shock. This leads to lower output, inflation, nominal interest rates, and real interest rates. 3) Explaining that a supply shock that increases inflation would be represented by a positive value on the Phillips curve and can be illustrated using an AD-AS diagram.

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sandrae brown
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161 views2 pages

Problem Set 5 Answers

This document contains sample answers to problems from an economics problem set. It addresses: 1) Solving a 5 equation model for long-run values and the impact of a change in full employment output. 2) Using the model to analyze the impact of a recession in other countries reducing tourism to Jamaica, representing a demand shock. This leads to lower output, inflation, nominal interest rates, and real interest rates. 3) Explaining that a supply shock that increases inflation would be represented by a positive value on the Phillips curve and can be illustrated using an AD-AS diagram.

Uploaded by

sandrae brown
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© All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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ECON 20031

Problem Set 5 - Answers

1. Using the 5 equation system of Chapter 15, assume that Ȳt = 100, ρ = 3.0, α = 1.0,
π ∗ = 2.5, φ = .25, θπ = 0.5, and θY = 0.5.

(a) Using the information above solve for the long run values of Yt , rt , it , and πt .
Be sure to state clearly any assumptions made in solving problem.
Answer
Yt = 100, rt = 3.0%, it = 5.5%, and πt = 2.5%
It has been assumed that the economy is in the long run and as such
inflation is constant for every period, and demand and supply shocks
are zero.
(b) Suppose full employment output changes to Ȳt = 200, illustrate on an appro-
priate diagram the change. Be sure to explain how this change can come about.
What will happen to the other endogenous variables in the system? Be sure to
provide economic intuition and a mathematical explanation for your answers.
Hint: The diagram you need can be found in the class slides.
Answer
Use the figure on slide 28 of the power point slides for Chapter
15. Anything that changes the long run aggregate supply curve will
cause a shift in Ȳt e.g. technological change. Note that any change
in Ȳt will necessarily cause a change in the short run AS curve. The
other variables in the system will remain fixed. With the increase in
the long run level of output there is no pressure on inflation for it
to deviate from its stable position. In other words, there is nothing
to suggest that peoples expectations about inflation have changed.
Moreover, in the long equilibrium the real interest rate will equal
to the natural rate. Since there is no change in the real interest
rate and the inflation rate then the nominal interest rate must also
remain unchanged.
(c) Explain why a positive value to vt (see Phillips Curve equation) is regarded as
a bad supply shock. Be sure to use an appropriate diagram to support your
answer.
Answer
A positive vt means that the shock causes the inflation rate to in-
crease. An increase in the rate of inflation is synonymous with a bad
supply shock i.e. the shock leads to a fall in actual output (income).
A well known example is that of the oil-price shocks of the 1970s.
Use the AD-AS framework to illustrate this situation, remember to
use the inflation rate instead of the price level.

2. 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 = 0.5, and θY = 0.25. Use this information to answer the following questions.

(a) A severe recession in the United States and Europe leads to a significant drop
in tourist arrivals to Jamaica. Of the two types of shocks represented in the
AD-AS framework, which one does this scenario represent?
1
Department
c of Economics, The University of the West Indies (Mona).

1
Answer
A drop in tourist arrivals to Jamaica is an example of a demand
shock.
(b) Suppose the shock described in part a enters the dynamic model with a value
of 1.5, and Yt = 99 (i.e. actual output falls from 100 to 99), you are required
to solve for the new values of rt , it , and πt .
Answer
To solve the system of equations one can start from either the goods
market equation or the Phillips Curve equation. These two equations
will give the values rt = 1.5, and πt = 1.5. Using these values in
the Fisher equation gives it = 3. Students are encouraged to use
the answers above to verify that they satisfy the monetary policy
equation.
(c) Do the values found in part b align with what economic theory dictates? Briefly
explain with the aid of a diagram.
Answer
Yes the values do align with what economic theory dictates. A fall in
demand causes the rate of inflation to fall. An appropriate diagram
will show a fall in AD (shift to the left) which results in a fall in
output and the inflation rate. With lower inflation and falling output,
the monetary policy rule dictates that the nominal interest rate must
fall. To be sure, to increase output the monetary authorities will
lower the interest rate, making borrowing easier or money cheaper,
and by extension increasing investment, consumption and . A falling
inflation rate and a falling nominal interest rate must result in a fall
in the real interest rate.

Common questions

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Technological change causes a rightward shift in the long-run aggregate supply curve, increasing potential output without immediate changes to inflation or the real interest rate. Inflation remains stable due to unchanged inflation expectations, keeping the nominal interest rate unchanged as well, provided there are no accompanying demand shocks .

A significant drop in tourist arrivals to Jamaica represents a demand shock. This is because the decrease in tourists reduces aggregate demand, affecting both the level of economic activity and employment .

With a change in full employment output to 200, there is a shift in the long run aggregate supply curve due to factors such as technological change. This shift does not exert pressure on inflation as it remains stable. As a result, the expectations about inflation do not change, and thus there is no change in the real interest rate, keeping the nominal interest rate unchanged as well .

A severe recession in major markets like the US and Europe causes a demand shock for Jamaica, reflected as a leftward shift in AD in the AD-AS framework. This results in decreased output (Yt falls), lower inflation rates due to reduced demand for goods and services, and subsequently a fall in nominal interest rates as monetary policy aims to stimulate demand through cheaper borrowing costs .

Changes in full employment output lead to a stable nominal interest rate when inflation remains constant, real interest rates do not change, and there are no shifts in inflation expectations. These conditions are met when long-run equilibrium is maintained without demand or supply shocks, keeping the systemic inflation rate and nominal interest rates stable .

After the demand shock, the values found are rt = 1.5, it = 3, and πt = 1.5. This aligns with economic theory as a fall in demand decreases inflation, shifting aggregate demand leftward. Lower inflation and output necessitate a fall in nominal and real interest rates, aligning with monetary policy rules to stimulate economic activity by making borrowing cheaper, enhancing investment and consumption .

In a demand shock scenario, real interest rates fall as a consequence of reduced economic activity, leading to lower inflation. Reduced inflation necessitates a decrease in nominal interest rates, following the principle that central banks lower rates to stimulate demand. This indirect relationship is governed by monetary policy rules and the Fisher equation, where nominal rates are adjusted to maintain economic stability .

A positive value of vt indicates an increase in inflation, akin to a bad supply shock which reduces actual output. This can be illustrated using the AD-AS framework where an increase in the inflation rate (depicted instead of the price level) reflects a leftward shift in the aggregate supply curve, similar to the oil-price shocks of the 1970s .

To solve for the long-run values of Yt, rt, it, and πt, assumptions include a constant inflation rate and the absence of demand and supply shocks. These hold as the system assumes long-run equilibrium where the real interest rate equals the natural rate and inflation expectations remain unchanged, resulting in stable nominal interest rates .

The Fisher equation relates the nominal interest rate to the real interest rate and inflation. After a demand shock, given the values of rt and πt, the Fisher equation can determine the new nominal interest rate by solving it = rt + πt, resulting in it = 3 .

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