Solutions to problem set 5
Part 1:
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1-
a)- True. b)- False. Basically the Phillips curve vanished after 1970. It is not stable, because it is a
function of expected price level. c)- True. While aggregate supply relation always reflects the reality.
d)- True. e)- False. Before 1970, when πe =0, then if π=0 u=un. f)- True.
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3-
a)- π=0 u=un un = 0.1/2=5%
b)- πt = 0.1 – 2 ut πt = 0.1 – 2 ut = 0.1 – 2 *3% = 4%, πt+1 = πt+2 = πt+10 = πt+15 = 4%
c)- No. Because, πte = 0, and πt =4% forever, which means people are continuously wrong for ever. This does
not seem to be reasonable.
d)- Because, finally, people realize that inflation is positive. But there will not change in natural rate of
unemployment.
e)- πt+1 = πt+2 = … = πt+4 = 4%
Year 5, and on: πt = πte + 0.1 – 2 ut πt = πt-1 + 0.1 – 2 ut, πt+5 = 4% + 0.1 – (2 * 3%) πt+5 = 8%
By continuous substitution: πt+10 = πt+9 + (0.1 – 2 *3%) = πt+8 + 2*(0.1 – 2 *3%) = …
πt+10 = πt+5 + 5*(0.1 – 2 *3%) = 8% + 5*(0.1 – 2 *3%) = 28%.
πt+15 = πt+10 + 5*(0.1 – 2 *3%) = 28% + 5*(0.1 – 2 *3%) = 48%.
f)- There is still and always a 4% difference between expected and actual inflation, which is not reasonable.
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5-
a)- πt = πte + 0.1 – 2 ut πt = πt-1 + 0.1 – 2 ut, πt = 0% + 0.1 – (2 * 4%) πt = 2%
πt+1 = 2% + 0.1 – (2 * 4%) πt+1 = 4% πt+2 = 4% + 0.1 – (2 * 4%) πt+2 = 6%
πt+3 = 6% + 0.1 – (2 * 4%) πt+3 = 8%
b)- πte = 0.5 * πt +0.5 * πt-1 , and πt = πte + 0.1 – 2 ut By substitution: πt = (0.5 * πt +0.5 * πt-1 ) + 0.1 – 2 ut,
After simplification, we get the new Phillips curve: πt = πt-1 + 0.2 – 4 ut,
c)- πt = πt-1 + 0.2 – 4 ut, πt = 0% + 0.2 – (4 * 4%) πt = 4%
πt+1 = 4% + 0.2 – (4 * 4%) πt+1 = 8% πt+2 = 8% + 0.2 – (4 * 4%) πt+2 = 12%
πt+3 = 12% + 0.2 – (4 * 4%) πt+3 = 16%
d)- Indexation leads to higher inflation rate at any level of unemployment.
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4-
a)- Because higher price of oil means higher production cost and higher output price at any given level of
wage rate. We can characterize this using higher markup.
b)- πe = π u=un. Therefore: un =0.04 +0.05 μ
Before the oil shock: un.=0.04 +0.05*0.2=0.05. After the oil shock: un.=0.04 + 0.05*0.4=0.06
So, oil shock increases the natural rate of unemployment.
Part 2:
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a)- False. Using Okun’s law for Canada: ut – ut-1 = -0.33(gyt – 3.7%), output growth rate must be 3.7% to
have constant unemployment rate.
b)- True. c)- True. d)- False. The growth rate of the money supply has a crucial role too, πt =gmt – gyt .
e)- False. πt =gmt – gyt, so inflation rate is equal to money growth rate minus output growth rate.
f)- True. g)- True. h)- True.
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2-
a)- ut – ut-1 = -0.33(gyt – 3.7%) 1% = -0.33(gyt – 3.7%) gyt = 0.7%. Output growth rate should be
large enough to cover the expansion of the labor force, and increase in the labor productivity.
b)- We need to decrease unemployment 0.25% a year. So: – 0.25 = -0.33(gyt – 3.7%) 4.45% a year.
c)- Okun’s law changes to: ut – ut-1 = -0.33(gyt – 5.7%)
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3)-
a)-
Phillips curve for the US: πt – πt-1 = – (ut – 5%), πt = πt-1 un = 5%
Phillips curve for Canada: πt – πt-1 = –0.5 (ut – 8.6%), πt = πt-1 un = 8.6%
b)- ut – ut-1 = -0.4(gyt – 3%), ut = ut-1 gyt = 3%
πt =gmt – gyt, 8% =gmt – 3% gmt = 11%
c)-
πt-1 =8%, ut-1 = 5%, gyt -1 = 3%, gmt-1 = 11%
πt =4%
πt – πt-1 = – (ut – 5%) 4% – 8% = – (ut – 5%) ut = 9%
ut – ut-1 = -0.4 (gyt – 3%) 9% – 5% = -0.4 (gyt – 3%) gyt = -7%
πt =gmt – gyt, 4% =gmt + 7% gmt = –3%
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πt+1 =4%
πt +1 – πt = – (ut+1 – 5%) 4% – 4% = – (ut+1 – 5%) ut+1 = 5%
ut+1 – ut = -0.4 (gyt+1 – 3%) 5% – 9% = -0.4 (gyt+1 – 3%) gyt +1 = 13%
πt +1=gmt+1 – gyt+1, 4% =gmt+1 – 13% gmt+1 = 17%
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πt+2 =4%
πt +2 – πt+1 = – (ut+2 – 5%) 4% – 4% = – (ut+2 – 5%) ut+2 = 5%
ut+2 – ut+1 = -0.4 (gyt+2 – 3%) 5% – 5% = -0.4 (gyt+2 – 3%) gyt +2 = 3%
πt +2=gmt+2 – gyt+2, 4% =gmt+2 – 3% gmt+2 = 7%
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4)-
a)-
πt – πt-1 = – (ut – 5%), ut – ut-1 = -0.4 (gyt – 3%), πt =gmt – gyt
πt – πt-1 = – (ut – 5%), ut – ut-1 = -0.4 (gmt – πt – 3%)
πt =10%, ut-1 = ut = 5%, gyt -1 = 3%, gmt = 13%
b)-
πt +1 – πt = – (ut+1 – 5%), ut+1 – ut = -0.4 (gmt+1 – πt+1 – 3%)
πt +1 – 10% = – (ut+1 – 5%) πt +1 + ut+1 = 15%
ut+1 – 5% = -0.4 (0 – πt+1 – 3%) ut+1 – 0.4 πt+1 = 6.2% ut+1 = 8.71%, πt+1 = 6.29%
πt +2 – πt+1 = – (ut+2 – 5%), ut+2 – ut+1 = -0.4 (gmt+2 – πt+2 – 3%)
πt +2 – 6.29% = – (ut+2 – 5%) πt +2 + ut+2 = 11.29%
ut+2 – 8.71% = -0.4 (0 – πt+2 – 3%) ut+2 – 0.4 πt+2 = 9.91% ut+1 = 10.3%, πt+2 = 1%
c)- πt +1 – πt = – (ut+1 – 5%), ut+1 – ut = -0.4 (gmt+1 – πt+1 – 3%)
In medium run ut+1 = ut πt+1 = – 3% ut =5% gyt = 3%.
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6-
πt – πt-1 = – (ut – 8.6%) +0.1μ πt – πt-1 = – (ut – un) and un = 8.6% + 0.1μ
a)- After the shock, natural rate of unemployment goes up. Therefore, current unemployment would fall
below natural rate of unemployment; therefore, inflation starts increasing (see the Phillips Curve form).
b)- They should let the unemployment go up, to higher level of natural rate of unemployment.
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7-
a)- πt = πte + K – 2 ut , πt = πte Natural rate of unemployment: un = ut= K/2
πt – πte = –2(ut –K/2) Sacrifice ratio = 1/2.
Sacrifice ration does not depend on natural rate of unemployment
b)- πt – πte = –2(ut –K/2), and πet = πt-1
πt – πt-1 = –2(ut –K/2) πt – 12% = –2*1% πt = 10%
πt+1 – πt = –2(ut+1 –K/2) πt+1 – 10% = –2*1% πt+1 = 8%
c)-
πt+2 – πt+1 = –2(ut+2 –K/2) πt+2 – 8% = –2*1% πt+1 = 6%
πt+3 – πt+2 = –2(ut+3 –K/2) πt+3 – 6% = –2*1% πt+1 = 4%
πt+4 – πt+3 = –2(ut+4 –K/2) πt+4 – 4% = –2*1% πt+1 = 2%
So, The authorities need to hold on the policy for 5 year, from t to t+4.
Sacrifice ratio= 5 point years of excess unemployment/10 percentage point reduction in inflation rate=0.5
Which is consistent with the sacrifice ratio calculated from Phillips curve in part (a).
d)- πt – πte = –2(ut –K/2), and πt = πt-1 πte = 0.25 * 2% + 0.75 * πt-1 πte = 0.5% + 0.75 * πt-1
πt – 0.5% – 0.75 * πt-1= –2(ut –K/2) πt – 0.75 * πt-1= –2(ut –K/2) +0.5%
πt – 0.75 * πt-1= –2(ut –K/2) +0.5% πt – 0.75 * 12%= –2*1% +0.5% πt = 7.5%
πt+1 – 0.75 * πt= –2(ut+1 –K/2) +0.5% πt+1 – 0.75 * 7.5%= –2*1% +0.5% πt+1 = 4.125%
πt+2 – 0.75 * πt+1= –2(ut+2 –K/2) +0.5% πt+2 – 0.75 * 4.125%= –2*1% +0.5% πt+2 = 1.594%
So, The authorities need to hold on the policy for 3 year, from t to t+2.
Sacrifice ratio= 3 point years of excess unemployment/10 percentage point reduction in inflation rate=0.3
Which is less than the sacrifice ratio calculated from Phillips curve in part (a).
e)- At the same time t+1, authorities can return to natural rate of unemployment.
πt+1 = πt+1e = 2%, un = ut+1= K/2
f)- They need to make sure to their policy has the highest credibility.
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