Four a consider the following relationships developed

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International Financial Management
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Chapter 18 / Exercise 17
International Financial Management
Madura
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QUESTION FOUR (a) Consider the following relationships developed in the ECON 202 Course: t - t-1 = - (ut - uut - ut-1 = - (gyt- where t is a time subscript denoting a year, =actual inflation rate, u= actual unemployment rate, un= natural unemployment rate, ytg= actual real gdp growth rate, yg= normal real gdp growth rate. Assume that in the current year t = t-1= 3%, ut= un= 6%, and gyt = Suppose that a government wishes to reduce inflation from 3% in the current year to 2% in year t+1. Suppose the government’s policy advisors assume that = 0.5 and  They accordingly recommend that the growth rate of real gdp needs to be reduced by 2% to 1% growth in year t+1 in order to reach the inflation target of 2 % in year t+1. Assume the government follows this advice. (i) Compute and explain what happens to the actual unemployment rate in year t+1 if the Okun Law coefficient, , were to be 0.25 rather than 0.5.(3 MARKS) (ii) If the Okun Law coefficient were in fact 0.5, compute and explain what happens to inflation in year t+1, relative to the announced inflation target, if the value of the Phillips Curve (PC) coefficient, , were to be 0.5 instead of 1.0. (3 MARKS) (iii) Compute and explain what happens to the range of inflation rates, as the range of possible values of and both vary simultaneously over the two values given in (i) for and in (ii) for .(3 MARKS) (iv) Comment briefly on the potential implications of the results in (iii) for policy credibility, in the context of New Zealand’s December 2008 Policy Targets Agreement (PTA) under the Reserve Bank of New Zealand Act, 1989. (3 MARKS) n)yg) yg= 3%. QUESTION FOUR CONTINUED ON NEXT PAGE
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Chapter 18 / Exercise 17
International Financial Management
Madura
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ECON 202Page 6 of 6 QUESTION FOUR (CONTINUED) (b) Recall one of the formulae for the government budget constraint derived in the ECON 202 course: tttttpdYBgrYB11)1(where Btis real gross government debt at the endof period t, Ytis the level of real GDP in period t,ris the real interest rate, gis the real economic growth rate, pdtis the ratio of the real primary deficitto GDP in period t, and t and t-1 are annual time subscripts. (i) Suppose that, at the beginningof year 1, the government debt to GDP ratio is 30%, and that during years 1, 2 and 3, the primary deficitis 4% of GDP, the real GDP growth rate is 1%, and the real interest rate is 3%. Calculate the government debt to GDP ratio for the endof years 1, 2 and 3. (3 MARKS) (ii) Suppose that rhad been 5% instead of 3%. Calculate the new government debt to GDP ratio for the endof years 1, 2 and 3. (3 MARKS) (iii) Continue to assume that, at the beginningof year 1, the government debt to GDP ratio is 30%. If the government’s public debt to GDP goal is to achieve a 20% target by the end of year 3, assuming r= .04 and g= .03, derive the annual average primary surplus or deficit (in percentage terms) necessary to achieve this 20% target. (7 MARKS)***************

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