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ans2 - Problem Set#2 ANSWERS Due Tuesday October 2 2007...

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Problem Set #2 ANSWERS (Fall 2007) 1/10 Problem Set #2 ANSWERS Due Tuesday, October 2, 2007 Problem Sets MUST be word-processed except for graphs and equations. QUESTIONS 1. In 1998, the U.S. economy was in equilibrium at potential GDP with an inflation rate of 4%. In 1999, there was a substantial increase in investment in anticipation of Y2K. In 2000, the Federal Reserve engaged in a contractionary monetary policy of exactly the size necessary to completely offset the increased investment in 1999. Also in 2000, autonomous investment fell, reversing all of its 1999 increase. a. Based only on this information, use a DAD – SAS model diagram to clearly show the effects of these events on equilibrium output and the inflation rate and during 1999, 2000, and 2001. Also be sure to clearly identify where the economy and inflation settle when the adjustment process is complete. SAS2 SAS3 SAS0 = SAS1 Y2 Y3 Y0 Y1 Y π π 2 π 3 π 0, π 1 π (final) DAD2 DAD0, 2a DAD1 Yn
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Problem Set #2 ANSWERS (Fall 2007) 2/10 b. Provide a brief economic explanation for what happened to economic output and inflation because of the events described above. Also be sure to discuss where economic output and inflation finally settle at the end of the adjustment process. Year 1 (1999): The increase in autonomous investment shifts the DAD curve from DAD0 to DAD1, raising the output from Y0 to Y1. Inflation holds steady at π 0 because inflation responds with a lag to changes in Y and u. Year 2 (2000): 3 things happen. First, because Y1 > Y0, inflation rises endogenously from π 0 to π 2, shifting the SAS curve from SAS0 to SAS2. Second, Fed tightening shifts the DAD curve back from DAD1 to DAD2a = DAD0. Third, the decline in autonomous investment shifts the DAD curve from DAD2a to DAD2. Higher inflation raises interest rates, reduces interest-sensitive spending, and decreases output to Y2 < Y0. Year 3 (2001): Because Y2 < Y0, inflation falls endogenously from π 2 to π 3, shifting the SAS curve down from SAS2 to SAS3. Lower inflation reduces interest rates, increases interest-sensitive spending, and increases output to Y3 < Y0. The adjustment process continues until inflation has fallen sufficiently to raise economic activity back to its natural level at Y0. This will be at the intersection of DAD2 and the horizontal natural output line at Y0.
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Problem Set #2 ANSWERS (Fall 2007) 3/10 2. Assume that the economy was operating at full employment in 1972 with a steady inflation rate. In 1973, there was a structural break in productivity growth. For the 10 years prior to 1973, productivity had grown by an average of 2.7% per year. For the 10 years following 1973, productivity grew by only 1.2%. Also in 1973, there was a quintupling of oil prices as OPEC raised the price of a barrel of crude oil from $2.50 to $12.50. Finally, in 1974, there was a major acceleration in military spending to fight the war in Vietnam. The full inflation adjustment process takes 7 years.
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