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Unformatted text preview: Midterm Economics 202 A Fall 2003 1. Monetary Policy A certain economy is described by the following aggregate demand equation: y t = m t p t The money supply rule followed by the monetary authority is given by a random walk process: m t = m t 1 + t , where t is an independent and identically distributed error term with zero mean. Assume that the equilibrium price level in that economy is given by the follow ing process: p t = αm t 1 + (1 α ) p t 1 + η t , where 0 6 α 6 1 and η t is an independent and identically distributed error term with zero mean. Assume that the process followed by t is independent to the process followed by η t . (a) Write y t as a function of m t 1 , p t 1 and error terms . (b) Show that y t follows an AR(1) process. For what values of α will the process be stationary? (c) Assuming potential output is normalized to zero, the Lucas aggregate supply curve is given by: y t = [ p t E t 1 ( p t )] + u t Can this equation be consistent with the economy described above? Do you need any assumption about α for your answer? 1 2. Rational Expectations True, False, or Uncertain? Justify your answer. “If individuals form their expectations rationally and there is no money illusion, only unpredictable monetary supply changes can affect real activity” 3. Unemployment The crucial assumption of efficiency wage theory is that the worker’s effort level, e , is positively related to the real wage level, w : e = e ( w ) ,wheree ( w ) > Assume that the unique input in the production function is now effective labor, so that the production function relating the number of goods produced, Q, to the number of effective labor units employed, eL , is given by: Q = F ( eL ) ,whereF ( eL ) > andF 00 ( eL ) < (a) Set the firm’s profit maximization problem and find the first order condi tions. (b) Derive the Solow Condition. (c) Suppose that the function relating effort to the real wage is of the form: e ( w ) = A + Bw γ , where A, B and γ are parameters. Assume A < 0, B > 0 and 0 < γ < 1. What real wage would the profit maximizing firm ideally pay? (d) Assume now that A is positive. What real wage would the profit maxi mizing firm ideally pay?...
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 Fall '07
 AKERLOF
 Economics, Inflation, Monetary Policy, Supply And Demand, Lucas aggregate supply

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