EC202 PS8solution

# EC202 PS8solution - EC202 Fall 2015 Problem Set 8 Chapter 7...

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EC202 - Fall 2015 - Problem Set 8 Chapter 7 # 8 Chapter 8 # 3, 5 Chapter 9 # 2, 6 1

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Chapter 7 Question 8 Assume that the economy starts at the natural level of output. Now suppose there is an increase in the price of oil. a. In an AS-AD diagram, show what happens to output and the price level in the short run and the medium run. Solution: The AS curve shifts up in the short run and shifts up further in the medium run. Output falls in the short run and falls further in the medium run. The price level rises in the short run and rises further in the medium run. b. What happens to the unemployment rate in the short run and the medium run? Suppose that the Federal Reserve decides to respond immediately to the increase in the price of oil. In particular, suppose that the Fed wants to prevent the unemployment rate from changing in the short run after the increase in the price of oil. Assume that the Fed changes the money supply once - immediately after the increase in the price of oil - and then does not change the money supply again. Solution: The unemployment rate rises in the short run and rises further in the medium run. c. What should the Fed do to prevent the unemployment rate from changing in the sort run? Show how the Fed’s action combined with the decline in business confidence affects the AS-AD diagram in the short run and the medium run. Solution: The Fed could increase the money supply in the short run and shift the AD curve to the right. The AS curve would still shift up over time because the natural level of output still is lower, which means that the current price level is still higher then the expectations (which haven’t changed) yet. As people adjust their expectations upward, the AS will shift toward the new natural level of output. d. 2
How do output and the price level in the short run and the medium run compare to your answers from part (a)? Solution: Output and the price level are higher in the short run in part (c). Output is the same in the medium run in parts (a) and (c), but the price level is higher in part (c). e. How do the short-run and medium-run unemployment rates compare to your answers from part (b)? Solution: The unemployment rate in the short run is lower in part (c), but the same in the medium run in parts (a) and (c). Chapter 8 Question 3 Suppose that the Phillips curve is given by π t = π e t + 0 . 1 - 2 u t a. What is the natural rate of unemployment? Assume that π e t = θπ t - 1 and suppose that θ is initially equal to 0. Suppose that the rate of unemployment is initially equal to the natural rate. In year t the authorities decide to bring the unemployment rate down to 3% and hold it there forever. Solution: The Phillips curve is give as π t = π e t + 0 . 1 - 2 u t . To find the natural rate of unemployment we need to assume π t = π e t and thus: π t = π e t + 0 . 1 - 2 u t π t = π t + 0 . 1 - 2 u t 0 = 0 . 1 - 2 u t 2 u t = 0 . 1 u t = 0 . 05 or 5% b.

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