Economics 251 Problem Set 4 Spring 2021

Economics 251 Problem Set 4 Spring 2021

Your Name (please print clearly) _____________________________
Economics 251: Spring 2021

Professor:
Intermediate Macroeconomics

Economics 251 Problem Set 4 Spring 2021 Problem Set 4, Part 1
Due: Friday April 16, 11PM csteven4@oberlin.edu & jduca@oberlin.edu
Economics 251 Problem Set 4 Spring 2021 Assignments to be handwritten then scanned into a single pdf (except for approved
disabilities), which is to be sent to csteven4@oberlin.edu & jduca@oberlin.edu with a subject
line of E251 Problem Set 4 Part 1. There is a 10-point penalty for an incorrectly named file. You
are responsible for naming your pdf file as follows: E251_PS4P1_yourlastname_yourfirstname.
For example, if your name were Janine Smith, your pdf file should be named:
E251_PS4P1_Smith_Janine.
1) Calculating Inflation in the Monetarist Model (4 points in total) Write down
the growth rate version of the modern quantity theory of money (1 point). According to
the basic assumptions of monetarism, what would most likely be the average annual
inflation rate if money growth equaled 23 percent, and trend real GDP growth equaled 9
percent (1 point)? Show your formulas and calculations. (1 point) Briefly discuss in one to
two sentences the main reason why most major central banks do not target money supply
growth (1 point).
2) Shifting the IS and MP Curves (21 Points in Total)
2A) Fiscal Policy (11 points). Assume that the monetary policy rule is unchanged in
problem (2A). Assume that the mpc is 0.80. If government spending is reduced by
$500 billion, what happens to the IS curve? Draw an initial IS curve and an MP curve
in a diagram with the real interest rate (r) on the y axis and real output (y) on the xaxis. Calculate by how much and in which direction the IS curve shifts horizontally (2
points). Draw the IS curve after the change in policy and indicate the new intersection
of the IS and the MP curves after the change in policy (2 points). Label the initial and
final curves, the initial and final equilibrium points, and label the initial and final
values of r and y on each axis. What can you say about the magnitude of the change
in output from the initial to the final level of output (1 pts.) and why (2 pts.)?
According to the gov’t spending multiplier = (1/(1-mpc)) = 1/(1-.80) = 1/.2 = 5,
In a separate diagram—this one with inflation on the y-axis and real output on the xaxis, depict the initial ISMP curve. Draw in the ISMP curve after the fiscal policy action
in problem 2A. (2 points) What can you say about the magnitude of the horizontal
shift of the ISMP curve compared to the horizontal shift of the IS curve (2 points)?
2B) Monetary Policy (5 points). Assume that fiscal policy is unchanged in problem (2B)
Draw an initial IS curve and an MP curve in a diagram with the real interest rate (r) on
the y axis and real output (y) on the x-axis. Draw a new MP curve assuming that the
central bank adopts a more stimulative/expansionary monetary policy rule and
indicate the new intersection of the IS and the MP curves after the change in policy (2
points). Label the initial and final curves, the initial and final equilibrium points, and
label the initial and final values of r and y on each axis.
In a separate diagram—this one with inflation on the y-axis and real output on the xaxis, depict the initial ISMP curve. Draw in the ISMP curve after the monetary policy
action in problem 2B. (1 point) What can you say about the magnitude of the
horizontal shift of the ISMP curve compared to the horizontal shift of the MP curve
(2 point)?
2C) An Economic Shock (5 points). Assume that the monetary policy rule and fiscal policy
is unchanged in problem (2C). Draw an initial IS curve and an MP curve in a diagram
with the real interest rate (r) on the y axis and real output (y) on the x-axis. Which
curve shifts and in which direction if there were a sudden rise in consumer and
business uncertainty (2 points). Indicate the new intersection of the IS and the MP
curves after the change in policy (1 points). Label the initial and final curves, the initial
and final equilibrium points, and label the initial and final values of r and y on each
axis.
In a separate diagram—this one with inflation on the y-axis and real output on the xaxis, depict the initial ISMP curve. Draw in the ISMP curve after the shock to
uncertainty in problem 2C. (1 point) What can you say about the magnitude of the
horizontal shift of the ISMP curve compared to the horizontal shift of the IS curve (1
point)?
3. (35 points) The Phillips Curve in Country A takes the form 𝝅 = 𝟑 − 𝟎. 𝟕𝟓(𝒖 − 𝟒) ,
where 𝝅 is the actual inflation rate (as opposed to the expected inflation rate) and 𝒖 is
the unemployment rate. The Phillips Curve in Country B takes the form 𝝅 = 𝟒 −
𝟎. 𝟓𝟎(𝒖 − 𝟔). The current unemployment rate in both countries is 4%.
a. (12 points) Calculate each of the following features of the Phillips Curve trade-off for
the two countries. (2 points for each correct answer)
Natural rate of unemployment: Country A %; Country B %
Expected rate of inflation: Country A %; Country B %
Actual rate of inflation: Country A %; Country B %
b. (8 points) Suppose policymakers implement policies that reduce the unemployment
rate to 2% in the short run. (You will redo problem (3a) except the current
unemployment rate in both countries is 2%.) Determine the impact on inflation in each
of the two countries (unchanged, up X percentage points, down X percentage points),
and explain any differences you see. (3 points for each correct change in inflation, 1
point for the explanation)
Change in inflation in Country A: percentage points.
Change in inflation in Country B: percentage points.
Explanation:
c. (15 points) Now assume price expectations are formed adaptively (𝑬𝝅 = 𝝅−𝟏) and that
both countries have been at their respective natural rates of unemployment long enough
that inflation is at the expected rate shown for each country in part a. Start from each
country having its unemployment rate at its natural rate in year 2021. If policymakers
implement policies aimed at keeping the unemployment rate at 2 percent that takes
effect starting in 2022, show what will happen in each country to the inflation rate over
the next five years.
Assume that u<un lowers inflation in the year it occurs for the expected inflation rate it
inherited from the prior year. Under the conditions, for 2021, Eπ = π in each country
10 points for the table, ½ point for each entry 2022 to 2025 and 2 for getting the entire
table correct.
Country A Country B
Year 𝑬𝝅 𝝅 𝑬𝝅 𝝅
2021 3.00% 3.00% 4.00% 4.00%
2022 % % % %
2023 % % % %
2024 % % % %
2025 % % % %
In which of the two countries do you think adaptive inflation expectations adaptively
would break down soonest? (2 points) Why? (2 points)

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