{[ promptMessage ]}

Bookmark it

{[ promptMessage ]}

Econ 154a Problem Set 10 Solution

Econ 154a Problem Set 10 Solution - Economics 154a Fall...

Info icon This preview shows pages 1–4. Sign up to view the full content.

View Full Document Right Arrow Icon
Economics 154a Fall 2005 Bj¨orn Br¨ugemann Problem Set 10 Solution Problem 1 (Inflation Expectations and the Cost of Reducing Inflation) 1. The initial situation is illustrated in Figure 1. Firms expect the money supply to be M 1 , which would give rise to the aggregate demand curve AD ( P | M 1 , . . . ). Thus the price level they expect is P e 1 , which is the expected price level for which the ag- gregate supply curve AS ( P | P e 1 ) goes through the intersection of the AD ( P | M 1 , . . . ) curve with the ¯ Y -line. Since the firms don’t believe the central bank’s announce- ment, they don’t revise their expectations and the AS curve does not change. 2. By construction, if the AS curve is AS ( P | P e 1 ), then the economy attains full em- ployment if and only if the central bank confirms the firms’ expectations and sets the money supply equal to M 1 . 3. If the central bank follows through and implements M 2 , this is an unanticipated monetary contraction. Output and employment fall below the full employment level. This is illustrated in Figure 2. 4. Let P e 2 be the price expected by firms if they fully believe the announcement by the central bank. This expected price level would give rise to the AS curve AS ( P | P e 2 ) illustrated in Figure 3. Clearly, if firms believe the central bank’s announcement, then the economy ends up in point E c 2 , so the economy attains full employment and prices (and thus inflation from period 0 to period 1) will be very low. If the announcement is not fully credible, then the short run equilibrium of the economy will be a point on the AD ( P | M 2 , . . . ) curve between the points E 2 and E c 2 . The more credibility the central bank has, the closer the short run equilibrium will be to E c 2 . Thus higher credibility implies that the central bank is more successful at reducing the price level and is able to achieve this with a smaller drop of output below full employment. In this sense bringing down inflation is easier for a central bank with a lot of credibility. Problem 2 (Problems of Money-Growth Targeting) 1. In class we obtained the formula M = cu + 1 cu + res BASE (1)
Image of page 1

Info icon This preview has intentionally blurred sections. Sign up to view the full version.

View Full Document Right Arrow Icon
Figure 1: AD - AS diagram Y P ¯ Y AD ( P | M 1 , . . . ) P e 1 AS ( P | P e 1 ) E 1 Multiplying both sides by cu + res cu +1 and switching sides yields BASE = cu + res cu + 1 M. Thus to achieve the target M T , the central bank must set the base equal to BASE T = cu + res cu + 1 M T . (2) 2. Since all deposits are now in saving accounts, M1 now only consists of currency in circulation, which is unaffected by the “financial innovation”. How can we compute the amount of currency in circulation? As a first step, notice that the ratio of currency in circulation and reserves can be written as RES CU = RES DEP CU DEP = res cu where in the first step both the numerator and the denominator were divided by deposits, and the second step uses the definition of res and cu. Multiplying through by RES yields RES = res cu CU . (3) Next recall the definition of the monetary base BASE = RES + CU 2
Image of page 2
Figure 2: Unanticipated Monetary Contraction Y P ¯ Y AD ( P | M 1 , . . . ) P e 1 AS ( P | P e 1 ) E 1 AD ( P | M 2 , . . . ) E 2
Image of page 3

Info icon This preview has intentionally blurred sections. Sign up to view the full version.

View Full Document Right Arrow Icon
Image of page 4
This is the end of the preview. Sign up to access the rest of the document.

{[ snackBarMessage ]}

What students are saying

  • Left Quote Icon

    As a current student on this bumpy collegiate pathway, I stumbled upon Course Hero, where I can find study resources for nearly all my courses, get online help from tutors 24/7, and even share my old projects, papers, and lecture notes with other students.

    Student Picture

    Kiran Temple University Fox School of Business ‘17, Course Hero Intern

  • Left Quote Icon

    I cannot even describe how much Course Hero helped me this summer. It’s truly become something I can always rely on and help me. In the end, I was not only able to survive summer classes, but I was able to thrive thanks to Course Hero.

    Student Picture

    Dana University of Pennsylvania ‘17, Course Hero Intern

  • Left Quote Icon

    The ability to access any university’s resources through Course Hero proved invaluable in my case. I was behind on Tulane coursework and actually used UCLA’s materials to help me move forward and get everything together on time.

    Student Picture

    Jill Tulane University ‘16, Course Hero Intern