Inflation and Run Equilibrium Values

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Problem Set # 4 [75 Points]
Econ 305 – Prof: Henry Terrell
Due: May 9th, 2008 before 9:00 AM

Name: ID: TA:

Problem 1 [25 Points]
Consider the following extended classical economy (in which the misperception theory holds): AD Y=600+20(M/P) SRAS Y=YFE +2(P - Pe) Okun’s Law (Y-YFE)/YFE=-2(u-unr) Full-employment output YFE=1000

Natural unemployment rate unr=0.06

a) Suppose that the money supply M=1000 and that the expected price level Pe=50. What are the short run equilibrium values of output Y, the price level P, and the unemployment rate u? What are the long run equilibrium values of these three variables? b) Now suppose that an unanticipated increase raises the nominal money supply to M=1260. What are the new short run equilibrium values of output Y, the price level P, and the unemployment rate u? What are the new long run equilibrium values of these three variables?

Problem 2 [25 Points]
In a certain economy the expectations-augmented Phillips curve is: (=(e – 2(u-unr) and unr=0.06

a) Graph the Phillips curve of this economy for an expected inflation rate of (e=0.1. If the Fed chooses to keep the actual inflation rate at 0.10, what will be the unemployment rate? b) An aggregate demand shock (increase in military spending) raises expected inflation to 0.12 (the natural unemployment rate is unaffected). Graph the new Phillips curve and compare it to the curve you drew in part (a). What happens to the unemployment rate if the Fed holds actual inflation at 0.10? What happens to the Phillips curve and the unemployment rate? c) Suppose that the supply shock raises expected inflation to 0.12 and raises the natural rate to 0.08. Repeat Part (b).

Problem 3 [25 Points]
Consider the following...
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