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The effects of a permanent decrease in the rate of nominal

money growth

Suppose that the economy can

be described by the following

three equations:

ut - ut-1 = -0.41gyt - 3%2 Okun's law

pt - pt-1 = -1ut - 5%2 Phillips curve

gyt = gmt - pt Aggregate demand

a. Reduce the three equations to two by substituting gyt from

the aggregate demand equation into Okun's law. (Okun's

law was presented in Chapter 2.)

Assume initially that ut = ut-1 = 5%, gmt = 13%, and

pt = 10%.

b. Explain why these values are consistent with the statement

"Inflation is always and everywhere a monetary


Now suppose that money growth is permanently reduced

from 13% to 3%, starting in year t.

c. Compute (using a calculator or a spreadsheet program) unemployment

and inflation in years t, t + 1, c, t + 10.

d. Does inflation decline smoothly from 10% to 3%? Why or

why not?

e. Compute the values of the unemployment rate and the inflation

rate in the medium run.

f. Is the statement that "Inflation is always and everywhere a

monetary phenomenon" a statement that refers to the medium

run or the short run?

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