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ECO202Y5 Quiz: HW4 - Supply side shock, disinflation, open-economy(1)

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Kathleen Wong

ECO202: Homework Assignment 4 1. True/False/Uncertain. Read the statements carefully. Decide whether the statement is true, false or uncertain. Explain your answer. Answers without an explanation will not receive credit. a. At the medium run equilibrium, the rate of inflation is equal to the rate of nominal money growth. b. The sacrifice ratio is equal to 1/α and indicates the number of percentage points the inflation increases for each percentage point unemployment increases by. c. The unemployment rate will rise by only a small degree if the Central Bank can quickly lower the inflation rate. d. Assume that the economy begins at a medium-run equilibrium. The Central Bank begins a disinflation process that will eventually cause inflation to fall permanently by 7 percentage points. The initial growth rate of the nominal money stock is 10%. True, False or Uncertain: When the economy settles into the new medium-run equilibrium, the new growth rate of the nominal money stock will be 5%. e. The Egyptian economy is currently at a medium-run equilibrium, with an inflation rate of 13%. The Central Bank of Egypt would like to set an inflation target of 6%. Egypt’s current growth rate of the nominal money stock is 18%. True, False or Uncertain: To achieve and maintain the inflation target, the Central Bank of Egypt must keep the growth rate of the nominal money stock equal to 6% when the Egyptian economy settles into the medium-run equilibrium. f. The Phillips curve says there is a direct relationship between the inflation and the unemployment rate. g. Suppose the price of raw materials used by firms increase, causing the mark-up rate to increase from 15% to 30%. Also suppose that Phillip’s Curve is given by e P t P t 0.15  0.2 3u t, where the mark-up rate (μ) is entered into the equation as decimal. True, False or Uncertain: As a result of the increase in firms’ mark-up rate, the natural rate of unemployment will increase from 6% to 8%. Your explanation should be supported by numerical evidence for your answer of true, false or uncertain. h. Suppose Canada and the United States are both open economies using a flexible exchange rate. Suppose that initially, Canada’s inflation rate is equal to 4% and the US inflation rate is 5%. Both the Bank of Canada and the Federal Reserve Bank (the US Central Bank) have promised to maintain these inflation rates forever. True, False or Uncertain: To keep the real exchange rate fixed, the Bank of Canada should depreciate the nominal exchange rate by 1% every year. 2. Suppose the following: Mexico’s economy consists of only one industry, telecommunications industry, which is initially dominated by a monopolist named Carlos Slim (according to Forbes, he’s the richest man in the world). The Mexican economy is initially at a medium-run equilibrium in Year 1. In the middle of Year 1, the Mexican Supreme Court passes a law that makes it illegal for a monopoly to exist. The law essentially forces Mr. Slim to sell parts of his company to other business owners. This introduces competition into to the telecommunications industry and reduces Mr. Slim’s market power. Using 1) the labor market, 2) the IS-LM graph, 3) the AS-AD graph, illustrate the effect of this law. You must provide an intuitive and theoretically-based explanation for why each of the curves is shifting as well as for the direction of the shift. 3. Immediately after the financial crisis of 2008, the United States (US) government initiated a temporary new program called the Emergency Unemployment Compensation (EUC) program, with the purpose of adding to the existing unemployment insurance benefits paid to unemployed workers (Unemployment Insurance is the US version of Canada’s EI). Because of the EUC, unemployed individuals in some states could receive up to 73 weeks of unemployment insurance benefits. Prior to the EUC program, the unemployed received only 26 weeks of benefits. The EUC program expired in December 2013. This meant that overnight (literally), some workers no longer qualified for unemployment insurance benefits because they already received more than 26 weeks of benefits. Of those that continued to qualify, they experienced a drastic cut in the number of weeks they would continue receiving benefits. Assume that the economy is at a medium-run equilibrium before December 2013. Using the labor market graph, the IS-LM graph, and the AS-AD graph, illustrate how the expiration of the EUC in December 2013 impacted the US economy and the adjustments necessary to reach the medium-run equilibrium in the space below. On the next page, you must provide a theory-based and dynamic explanation for why specific curves are shifting and the direction of the shift. 4. Suppose the Central Bank is currently at a medium-run equilibrium, but wants to decrease inflation by 12 percentage points, from 16% to 4%, in 4 years. As a firm believer in the traditional approach of reducing inflation, describe the policy you would recommend by filling in the table below. To fill in the table, calculate the target path of inflation, the path of unemployment, the path of output growth and the nominal money growth assuming that α = 0.5 (from Phillips Curve) and β = 0.75 (from Okun’s Law). You should show your work or provide an explanation for how you derived the numbers in your answer. Year Before Disinflation Process After 0 1 2 3 4 5 6 7 Inflation (%) 16 Unemployment Rate (%) 5 Output Growth (%) 3 Nominal Money Growth (%) 19 5. Suppose you’ve been given the following information. The Bank of Canada is trying to lower the inflation rate by 12 percentage points. They are considering the timing of which to accomplish this goal and have asked you to consider various time periods to complete the goal. Complete the following tasks. You may continue on the other side of the page if necessary. 1) In the table below, determine the unemployment rate required in each year, for each of the policy options. The natural rate of unemployment is 10% and that the value of α is equal to ¼. Answers without work will not receive credit. 2) Given your calculations, which policy would be more appropriate for Canada, a policy that takes place in a shorter period of time or a longer period? Why? Unemployment Length of Rate for Each Year Policy the Policy is In Effect 1 year 2 years 3 years 4 years 6 years 12 years 6. The Bank of England is concerned that their inflation rate is too low and wants to permanently raise the current inflation rate by 9 percentage points. The economy is currently (period 0) at a medium-run equilibrium, and they want to achieve the process over a 3-year period. Year Before Disinflation Process After 0 1 2 3 4 Inflation (%) 2 [1] [2] [3] [4] Unemployment Rate (%) 7 2 [5] [6] [7] Output Growth (%) 4 24 [8] [9] [10] Nominal Money Growth (%) [11] [12] [13] [14] [15] a. Using the information provided to you i
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