Question 1: The labor force participation rate equals

A) the ratio of the total population to the population aged 16-64

B) the ratio of the number of people employed to the total population
C) the ratio of the number of people employed to the active population
D) the ratio of the active population to the population aged 16-64

See

Question 2: Prices are set as a fixed markup over wages. The markup depends on
A) The competition in the market for goods
B) The skill level of the labor force
C) The expected price level
D) the labor productivity
Question 3: Assume that 𝜋 = 𝜋 + 0,1 − 2𝑢 . The natural rate of unemployment equals
A) 0,05
B) 0,20
C) 0,1
D) 0

You would find the natural rate of unemployment as the level where expected inflation equals
inflation, i.e. where 0,1 – 2ut = 0, i.e where u = 0,05 of 5%
Figure

Use the figure to solve the question. The closed economy is initially in point E where the real interest r
equals rn and output equals Yn. In point E both the goods market (IS1) and financial market (LM1) are in
equilibrium.

Question 4: Assume that inflation expectations are backward looking and are equal to last year’s
inflation (i.e. in figure 1 assume that eAssume that government reduces government
consumption G, that the government collects a lump sum tax T. The economy will move from
equilibrium E to equilibrium A. After some time, the central bank lowers its real policy rate r from
rn to r’n. The economy moves from equilibrium A to the new equilibrium B. Compare equilibrium
E with equilibrium B
A) In E unemployment will be higher compared to unemployment in B
B) In E unemployment will be lower compared unemployment B
C) In E unemployment will equal unemployment in B
D) Without additional inflation data, it is impossible to predict how unemployment in B will
compare to unemployment in A.

In E and B, the economy is in its medium run equilibrium. If follows that output and unemployment
are equal to their potential or natural rate. In E and B unemployment will be the same.
Question 5: Use figure 1. Assume that inflation expectations are equal to a constant (i.e. in figure
1 assume that e    Assume that government reduces government consumption G, that the
government collects a lump sum tax T. The economy will move from equilibrium E to equilibrium
A. After some time, the central bank lowers its real policy rate r from rn to r’n. The economy moves
from equilibrium A to the new equilibrium B. Compare equilibrium E with equilibrium B
A) In B investment will be higher compared to investment in E
B) In B consumption will be higher compared to consumption in E
C) In B tax revenue will be higher compared to the tax revenue in E
D) In B the budget deficit will be higher compared to the deficit in E

In E and B, the economy is in its medium run equilibrium. However, in B, the real interest rate is below
the real interest rate in E. It follows that in B, investment will be higher than in E. Consumption will be
the same, output hasn’t changed, taxes are lump sum so constant across income. Given that the
government collect a lump sum tax, tax revenues will be the same. Given the lump sum tax and lower
G, the government deficit will be smaller in B compared to E.

Question 6: Use figure 1. Assume that inflation expectations are equal to a constant (i.e. in figure
1 assume that e   Assume that government reduces government consumption G, that the
government collects a lump sum tax T. The economy will move from equilibrium E to equilibrium
A. After some time, the central bank lowers its real policy rate r from rn to r’n. The economy moves
from equilibrium A to the new equilibrium B. Compare the nominal interest rate in equilibrium E
with the nominal interest rate in equilibrium B
A) The nominal interest rate will be higher in E than the nominal interest rate in B
B) The nominal interest rate will be lower in E than the nominal interest rate in B
C) The nominal interest rate will be equal in E to the nominal interest rate in B
D) Without additional money demand data, it is impossible to predict how the nominal interest
rate in E will compare with the nominal interest rate in B.

In B, the real interest rate is lower than in E (LM curve shifted down as the central bank reduced its
policy rate). In both B and E, expected inflation is the same as it is equal to a fixed level. It follows that
nominal interest rates (real rates + expected inflation) will be higher in the old equilibrium E compared
to the new equilibrium B.
Question 7: Use figure 1. Assume that inflation expectations are backward looking and are equal
to last year’s inflation (i.e. in figure 1 assume that eAssume that government reduces
government consumption G, that the government collects a lump sum tax T. The economy will
move from equilibrium E to equilibrium A. After some time, the central bank lowers its real policy
rate r from rn to r’n. The economy moves from equilibrium A to the new equilibrium B. Compare
equilibrium E with equilibrium B
A) In E inflation will be higher compared to inflation in B
B) In E inflation will be lower compared inflation B
C) In E inflation will equal inflation in B
D) Without additional unemployment data, it is impossible to predict how inflation in B will
compare to inflation in A.

Here the dynamics are crucial: as the economy fall in a recession, unemployment will increase as the
economy moves from E to A. This causes inflation to fall. As expected inflation is backward looking, it
means that expected inflation will fall. Note that inflation will continue to fall as long as output is
below potential. Hence, in the new equilibrium B, inflation will be lower than in the old equilibrium E.

Assume the following model:

Okun’s Law: ut  ut 1  0, 6gy (1)

Phillips curve: t  e  0, 4 u  un  (2)

Question 8: Assume that the economy is in its medium run equilibrium and that the natural rate
of unemployment equals 5%. Assume that the economy grows with 5%. Unemployment would
A) Rise from 5% to 8%
B) Not change from its medium run equilibrium
C) Fall from 5% to 2%
D) Rise from 5% to 7%

From Okun’s law: ut  ut 1   0, 6gy  0, 6 * 0, 05  0, 03 : unemployment will fall 3 percentage
points below its natural level from 5% to 2%
Assume the following model:

Okun’s Law: ut  ut 1  0, 6gy (3)

Phillips curve: t  e  0, 4 u  un  (4)

Question 9: Assume that the unemployment rate falls from 5% to 3% in t+1. Also assume that
expected inflation is fixed at 2%. Inflation in t+3 will
A) Rise from 2% in t, to 2,8% in t+3
B) Be equal to 2% in t+3
C) Fall from 2% in t, to 1,2% in t+3
D) Rise from 2% in t, to 4,4% in t+3

From the Phillips curve with anchored (fixed) expected inflation equal to 2%: if unemployment falls 2
percentage points below its natural rate, than inflation will increase with 0,8% above its natural rate

t  e  0, 4 u  un   t  e  0, 4 3%  5%  0, 8 . As expected inflation is fixed, the

difference between expected inflation and inflation will be constant in time as long as the
unemployment rate stays at 3%.

Assume the following model:

Okun’s Law: ut  ut 1  0, 6gy (5)

Phillips curve: t  e  0, 4 u  un  (6)

Question 10: Assume that expected inflation is backward looking. In t, inflation equals 2% and the
economy is in its medium run equilibrium. Assume that unemployment falls from 5% to 4% in t+1.
The central bank wants to move the economy back towards its medium run level in t+6. In order
to do so, the central bank will change its policy rate to reduce output and increase unemployment.
What is the level of unemployment in t+6 that would bring the economy back towards its medium
run equilibrium.
A) In t+6, the unemployment rate must equals 5%
B) In t+6, the unemployment rate must equal 9%
C) In t+6, the unemployment rate must equal 10%
D) In t+6, the unemployment rate must equal 8%

Here, you must first calculate inflation and expected inflation from t+1 to t+5 where expected inflation
in t+2 equals inflation in t+1, … As the table shows, inflation will equal 0,04 or 4% in t+5.

It follows that expected inflation in t+6 will be 4% (i.e. equal to inflation in t+5). If the central bank
wants to move the economy back towards an equilibrium with 2% inflation, the needs to ‘cause’ 10%
unemployment in t+6? If that is the case, from the Phillips curve, inflation will fall to 2%. If the central
bank normalizes policy afterwards, inflation will equal expected inflation in t+7 as expected inflation
in t+7 will be equal to inflation in t+6 = 2%
 Phillips backward looking expected inflation
 t-1 a u un
t+1 0,024 0,02 -0,4 0,04 0,05
t+2 0,028 0,024 -0,4 0,04 0,05
t+3 0,032 0,028 -0,4 0,04 0,05
t+4 0,036 0,032 -0,4 0,04 0,05
t+5 0,04 0,036 -0,4 0,04 0,05

Inflation back in line requires the unemployment rate to change to

t+6 0,02 0,04 -0,4 0,1 0,05