f01_ps8ans - 14.02 - Fall 2001 Problem Set 8 Solutions...

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14.02 - Fall 2001 Problem Set 8 Solutions Posted November 30, 2001 I. True/False (30 points, 5 each) 1. TRUE, a decrease in the price of oil is re f ected in a reduction of the mark-up μ (the interpretation story described in your text book). The natural rate of unemployment declines, the natural level of output increases, so the AS shifts to the right, and in the medium run the price level is lower. Thus, for a F xed nominal supply of money, the real money supply will increase, which will result in a lower interest rate. 2. TRUE, the two policies have o f setting e f ects on output but both reduce the interest rate (they are usually implemented to change the mix of private vs government investments). If the AD shifts to the left because the monetary authority miscalculates the increase in M (so we have an excessive monetary contraction), then in the medium run the price level will be lower which further reduces the interest rate. 3. TRUE, more competition in the goods market reduces the mark-up, and the analysis become analogous to question 1. 4. TRUE, let u true n >u estimated n and π i t π t 1 = α ( u t u i n ) , then the authority trying to equate u t with u estimated n will let π be larger than necessary. 5. TRUE, as long u t is larger than u n ,wehaveanega t ivechangeinthe in f ation rate (ie, in f ation is decreasing while the unemployment rate is above its natural rate, with the decrease being smaller the closer u t is to u n ), but as soon as u t <u n then you expect to see the change in in f ation to become positive. Therefore, π increases over time. —Of course, if you assumed (and stated) that we were talking about the absolute value of the change in in f ation, then your answer would have to be FALSE, since the magnitude of π will decrease (as long as it is negative) only to start increasing again (once it becomes positive).
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0 2 4 6 8 93 94 95 96 97 98 99 00 INFLATION UNRATE 6. FALSE, indexation increases the e f ect of unemployment on in f ation: with indexation wages respond to price right away. In a standard economy, a given decline in the unemployment rate will have a positive impact on wages (through wage setting) which will in turn have a positive impact on prices (through price setting). Then, this increase in the current level of prices will shift price expectations for the next period up, and then we will have a further increase in wages and prices in the next period. But in an economy where a large fraction of workers earn wages that are indexed to in f ation, then the same initial increase in P from the same original decline in u t will actually feed back into further increase in the wages of those who are currently covered by wage indexation. This increase in wages will produce a further increase in the price level in this current period —which will in turn cause higher wages, and so on. .. As a result, a given reduction in the unemployment rate will produce higher
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f01_ps8ans - 14.02 - Fall 2001 Problem Set 8 Solutions...

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