Textbook Notes (367,974)
Canada (161,538)
York University (12,784)
Economics (1,011)
ECON 2450 (21)
Chapter

Answers_11_2450_10.pdf

8 Pages
103 Views
Unlock Document

Department
Economics
Course
ECON 2450
Professor
Frank Marchese
Semester
Fall

Description
Answers to Practice Exercises on Chapter 11 Analytical Exercise 2 If the prevailing expectations in the economy are rational expectations, labour contracts do not overlap, and if workers, managers, and investors have sufficient foreknowledge of the change in policy, then it will affect the price level and the inflation rate, but not the level of real GDP or unemployment. Analytical Exercise 3 It would raise inflation, and raise the price level. Analytical Exercise 6 Suppose half the contracts are signed at the beginning of the period and half the contracts in the middle of the period. In the figure below the initial full employment equilibrium is at point A, with the monetary policy reaction function at MPFR and0the Phillips Curve at PC 0 Suppose after all the contracts are signed at the beginning of the period, the central bank announces that it will lower its target interest rate r* starting in the second half of the period. (That this policy is expansionary was discussed in Analytic Exercise #7 of Chapter 10.) The announcement of the policy will affect labour contract negotiations in the middle of the period. As only half of the workers and firms are engaged in labour negotiations, they will be worried about their position relative to the other half of workers and firms; and they will not raise the wage rates in order to stay competitive. As a result in the middle of the period wages will increase by a very small amount, and the Phillips curve will shift up by a small amount, to PC . The 1eduction in r* will also shift up the monetary policy reaction function to MPRF . The 1quilibrium in the second half of the period will be at point B. Hence, the anticipated expansionary policy will reduce the unemployment rate even though expectations are rational. Policy Exercise 6 a. In year zero, actual ieflation is equal to expected inflation. The Phillips curve equation: πt=π −βt×(u −u *) t t tells us that this is true only when unemployment is at its natural rate of six percent. So in year zero unemployment is six percent. According to the MPRF-Taylor Rule equation as it stands in year zero, unemployment is six percent only when inflation is 2%. So inflation in year zero is 2%. b. If the economy has rational expectations, then because the shift in policy was known and anticipated beforehand, expected inflation will be equal to actual inflation. From the Phillips curve equation, this holds only when unemployment is six percent. So unemployment is six percent in year one and for every year thereafter. The MPRF equation: ut = u0t φ × (π t π ' t) with parameter values for year one and thereafter substituted into it: ut = 0.004+ 0.4 × (π t .02 ) tells us that unemployment is six percent only when inflation is seven percent. So u =.06 t and π t.07 at all times t greater than or equal to one. The government’s attempt to pursue an expansionary policy has, under rational expectations, no effect at all on unemployment, but serves to raise the inflation rate from 2 to 7% per year. c. If the economy has adaptive expectations, then this year’s expected inflation is last year’s actual inflation. Substituting in this definition of adaptive expectations and the values of the parameters produces the two adaptive-expectation equations: π = π − 0.5× (u −.06) t t−1 t ut= 0.004+ 0.4 × (π t .02 ) Substituting the second equation into the first to solve for the path over time of inflation produces: π = (5/6)π + (7/600) t t−1 And once inflation in any year is known, calculating unemployment can be done by straightforwardly applying the MPRF equation: u = 0.004+ 0.4 × π − .02 ) t t Beginning to calculate this equation for t=1, for the first year in which the policy is in effect, and then calculating forward in time for 35 years tells us that inflation and unemployment follow the following path over time: AN EXPANSIONARY POLICY UNDER ADAPTIVE EXPECTATIONS Year Unemployment Inflation 0 0.06 0.02 1 0.043333333 0.028333333 2 0.046111111 0.035277778 3 0.048425926 0.041064815 4 0.050354938 0.045887346 5 0.051962449 0.049906121 6 0.05330204 0.053255101 7 0.054418367 0.056045918 8 0.055348639 0.058371598 9 0.056123866 0.060309665 10 0.056769888 0.061924721 11 0.05730824 0.063270601 12 0.057756867 0.064392167 13 0.058130722 0.065326806 14 0.058442269 0.066105672 15 0.058701891 0.066754726 16 0.058918242 0.067295605 17 0.059098535 0.067746338 18 0.059248779 0.068121948 19 0.059373983 0.068434957 20 0.059478319 0.068695797 21 0.059565266 0.068913164 22 0.059637721 0.069094304 23 0.059698101 0.069245253 24 0.059748418 0.069371044 25 0.059790348 0.06947587 26 0.05982529 0.069563225 27 0.059854408 0.069636021 28 0.059878674 0.069696684 29 0.059898895 0.069747237 30 0.059915746 0.069789364 31 0.059929788 0.06982447 32 0.05994149 0.069853725 33 0.059951242 0.069878104 34 0.059959368 0.06989842 35 0.05996614 0.06991535 The first year of the policy sees the economy boom—unemployment falls to 4.33%--and inflation rise slightly. Thereafter every year sees the adaptive expectations of the economy revise expected inflation upward slightly. The new higher level of expected inflation induces the central bank to raise interest rates and so raise unemployment, and over time the economy heads for the same equilibrium—inflation at 7%, unemployment at 6%--as in the rational expectations economy of part b. But while the long-run equilibrium in which actual equals expected inflation comes immediately under rational expectations, it is reached only in the long run under adaptive expectations. d. Under static expectations, expected inflation remains at 2%, and so in year one the economy attains the same unemployment-inflation configuration—4.33% for unemployment, 2.83% for inflation—attained under adaptive expectations. But because expectations of inflation are static, the economy remains at that point thereafter. Policy Exercise 7 a. The initial level of unemployment is the same as it was in question 4: 6%. (So is the initial level of inflation: 2%). b. Under rational expectations, as argued in the answer to question 4 above, unemployment is always 6% as long as the economic policies of the government are understood and anticipated. Moreover, expected inflation is equal to actual inflation. Since the central bank has raised its target inflation rate to 4%, and since that is the inflation rate consistent with 6% unemployment, actual inflation and expected inflation jump immediately to that 4% level as well. c. The logic is the same as in part c of question 4 above, only this time it is the central bank’s tolerance for inflation that has shifted. The Phillips curve and MPRF equations from year one on are: π t π t−1− 0.5× (u −t06) u t= 0.06+ 0.4 × π t .04 ) Substituting this second equation into the first produces an equation for the dynamic path over time of the inflation rate: π t (5/6)π t−1+ (2/300) And once inflation in any year is known, calculating unemployment can be done by straightforwardly applying the MPRF equation: u t 0.06+ 0.4 × π t .04 ) Beginning to calculate this equation for t=1, for the first year in which the policy is in effect, and then calculating forward in time for 35 years tells us that inflation and unemployment follow the following path over time: AN EXPANSIONARY POLICY UNDER ADAPTIVE EXPECTATIONS Year Unemployment Inflation 0 0.06 0.02 1 0.053333333 0.023333333 2 0.054444444 0.026111111 3 0.05537037 0.028425926 4 0.056141975 0.030354938 5 0.056784979 0.031962449 6 0.057320816 0.03330204 7 0.057767347 0.034418367 8 0.058139456 0.035348639
More Less

Related notes for ECON 2450

Log In


OR

Join OneClass

Access over 10 million pages of study
documents for 1.3 million courses.

Sign up

Join to view


OR

By registering, I agree to the Terms and Privacy Policies
Already have an account?
Just a few more details

So we can recommend you notes for your school.

Reset Password

Please enter below the email address you registered with and we will send you a link to reset your password.

Add your courses

Get notes from the top students in your class.


Submit