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1ECO 583Fall 2010 Assignment 2 Dr. GhoshAnswer all questions. Provide detailed explanation. Show and explain allcalculations. Draw graphs whenever necessary.1. (a) Suppose that the economy is currently at the full employment position.Using the AS-AD and IS-LM models explain the short run and mediumrun impacts of a decrease in budget deficit. Be sure to explainthe shifts of the curves and the dynamic adjustment of the economy.(10)(c) Suppose that the economy is currently at the full employment position.Using the AS-AD and IS-LM models explain the short run and medium runimpacts of a decrease in money supply. Be sure to explain the shifts ofthe curves and the dynamic adjustment of the economy. In this contextexplain the concept of neutrality of money.(10)2. (a) The current inflation rate (in year 0) in an economy is 18% and the currentunemployment rate is 6%. The natural rate of unemployment is 6%, thenormal (GDP) growth rate is 3%. The coefficients for the Phillips Curveand the Okun’s Law are 1 and 0.5 respectively. Suppose thecentral bank wants to begin a process of disinflation in year 1 such thatinflation is reduced every year by 3% until it reaches the desired level of3%. Given this desired path of inflation, calculate the paths ofunemployment, output growth rate and nominal money growth for years 1through 7. Show and explain all your calculations and in particular, explainwhy does each variable change as they do.(28)(b) Suppose that labor productivity is growing at the rate of 3% per year. Iflabor force is growing at the rate of 1% per year, calculate the rate ofoutput growth that can keep the rate of unemployment constant.(4)(c) In an economy the central bank wants to reduce the inflation rate by 9%.Given that the coefficient of the Phillips Curve is given by 1.15,2calculate the number of point years of excess unemployment and thesacrifice ratio. Given the goal of reducing inflation by 9%, can the centralbank affect the number of point years of excess unemployment calculatedabove? Explain. Can the central bank affect the distribution of excessunemployment over time? If so explain how. If not explain why not.(8)3. (a) An economy is described by the following equations:AD: Y = 4000+2 (M/P)AS: Y = Yn + 100 (P – Pe)Okun’s Law: (Y – Yn)/Yn = -2 (u-un)The natural rate of output, Yn = 6000, and the natural rate ofunemployment, un = .05 (or 5%).(i) The money supply has long been constant at M = 4000. Currently, theeconomy is producing the natural rate of output and it has been operatingat the level for the past few years. Calculate the current price level,expected price and unemployment rate.(ii) Suppose that money supply unexpectedly increases to 4488. Using theAD-AS model calculate the short run and medium run impacts of such anincrease in money supply. In particular calculate the short run and mediumrun equilibrium values of the price level, expected price, unemploymentand output.(Hint: You may need to use the following formula to solve a quadraticequation.If ax2 + bx +c = 0Then, the values of x can be calculated asab b acx24 2 .)(18)(b) In an economy the equation for the expectations augmented Phillips curveis given by:2( ) ne u u3Where, the natural rate of unemployment, un is 6% (or .06).(i) Draw the graph of the Phillips curve with inflation along the vertical axisand unemployment along the horizontal axis if the expected inflation rateis 10% (or .10). Calculate the unemployment rate, if the Fed chooses tokeep the actual inflation rate at 10%.(ii) Suppose that an aggregate demand shock (resulting from an increasedmilitary spending) raises expected inflation to 12%, leaving the natural rateof unemployment unchanged. Graph the new Phillips curve and show itsrelationship to the one drawn in part (i) above. Calculate theunemployment rate, if the Fed chooses to keep the actual inflation rate at10%. What happens to the unemployment rate if, after the demand shock,the Fed announces that it will maintain the inflation rate at 10% and thatannouncement is fully believed by the public?(iii) Suppose that instead of a demand shock, a supply shock such as anincrease in price of oil raises expected inflation to 12% and raises thenatural rate of unemployment to 8%. Graph the new Phillips curve andshow its relationship to the one drawn in part (i) above. Calculate theunemployment rate, if the Fed chooses to keep the actual inflation rate at10%.(12)(c) Consider a country with two political parties, Democrats and Republicans.Democrats care more about unemployment than Republicans, andRepublicans care more about inflation than Democrats. When Democratsare in power, they choose an inflation rate D and when Republicans are inpower, they choose an inflation rate R .We assume that D > R .An election is about to be held. Assume that expectations about inflation forthe coming year (represented by ) are formed before the election.(Essentially, this assumption means that wages for the coming year are setbefore the election.)The Phillips curve is given by( ) et t ut unwhere the natural rate of unemployment, n u = 6%.(i) Calculate the expected inflation rate, et in terms of D and R .(ii) Suppose D = 5.1% and R = 3.6%.Suppose the Democrats win the election and implement their targetinflation rate.4Calculate the unemployment rate, t u(iii) Suppose, instead, the Republicans win the election and implement theirtarget inflation rate.Calculate the unemployment rate.(iv) Now, Suppose that everybody expects the Democrats to win the election,and the Democrats indeed win and implement their target inflation rate.Calculate the expected inflation rate and the resulting unemployment rate.(v) Explain the differences in unemployment rates, particularly in relation to thenatural ate of unemployment, as calculated in (ii) –(iv) above.(For (ii) –(iv) Calculate your answer as a percentage rounded to onedecimal place.)(10)GOOD LUCK!!