Foundations of Economics for International Business Supplementary Exercises 7

Transcription

1 Foundations of Economics for International Business Supplementary Exercises 7 INSTRUCTOR: XIN TANG Department of World Economics Economics and Management School Wuhan University Fall MULTIPLE CHOICES These tests are only for your practice, you do NOT have to hand them in. However, all materials in the supplementary tests are also subject to be tested in exams. Check the answers carefully! 1. The basic aggregate supply equation implies that output exceeds natural output when the price level is: (A) low. (B) high. (C) less than the expected price level. (D) greater than the expected price level. 2. Starting from the natural level of output, an unexpected monetary contraction will cause output and the price level to in the short run, and in the long run the expected price level will, causing the level of output to return to the natural level. (A) increase; increase (B) increase; decrease (C) decrease; decrease (D) decrease; increase 3. Along any aggregate supply curve, there is only one: (A) unemployment level. 1

2 (B) expected price level. (C) inflation level. (D) output level. 4. If the short-run aggregate supply curve is steep, the Phillips curve will be: (A) flat. (B) steep. (C) backward-bending. (D) unrelated to the slope of the short-run aggregate supply curve. 5. The NAIRU is the: (A) North American institutional rate of unemployment. (B) natural aggregate investment return on utilization. (C) non-accelerating inflation rate of unemployment. (D) normal American inelastic rate of unemployment. 6. If the equation for a country s Phillips curve is π = (u 0.05), where π is the rate of inflation and u is the unemployment rate, what is the short-run inflation rate when unemployment is 4 percent (0.04)? (A) above 2 percent (0.02) (B) below 2 percent (0.02) (C) 2 percent (0.02) (D) 2 percent ( 0.02) 7. In the case of demand-pull inflation, other things being equal: (A) both the inflation rate and the unemployment rate rise at the same time. (B) the unemployment rate rises but the inflation rate falls. (C) the inflation rate rises but the unemployment rate falls. (D) both the inflation rate and the unemployment rate fall. 8. Assume that the sacrifice ratio for an economy is 4. If the central bank wishes to reduce inflation from 10 percent to 5 percent, this will cost the economy percent of one year s GDP. (A) 4 (B) 5 (C) 20 2

3 (D) The assumption of rational expectations for inflation means that people will form their expectations of inflation by: (A) optimally using all available information, including information about current policies, to forecast the future. (B) asking the opinions of the best experts. (C) subscribing to the forecasting service that uses the best econometric model. (D) basing their opinions on recently observed inflation. 10. Advocates of the rational expectations approach predict that a credible policy to lower inflation will the sacrifice ratio. (A) raise (B) lower (C) not change (D) sometimes raise and sometimes lower 11. Assume that an economy has the Phillips curve π = π 1 0.5(u 0.06). How many percentage point-years of cyclical unemployment are needed to reduce inflation by 5 percentage points? (A) 20 (B) 10 (C) 5 (D) SHORT ANSWERS AND NUMERICAL PROBLEMS Remember you have to show the detailed calculation, reason, induction or any other necessary process of your solution. 1. Suppose that an economy has the Philips curve (a) What is the NAIRU? π = π 1 0.5(u 0.06) (b) Graph the short-run and long-run relationships between inflation and unemployment. (c) How much cyclical unemployment is necessary to reduce inflation by 5 percentage points? Using Okun s law, compute the sacrifice ratio. 3

4 (d) Inflation is running at 10 percent. The Fed wants to reduce it to 5 percent. Give two scenarios that will achieve that goal. 2. Assume that people form expectations rationally and that the sticky-price model describes the aggregate supply curve in the economy. For each of the following scenarios, explain whether or not monetary policy can have real effects on the economy: (a) The central bank determines monetary policy using the same information available to all firms and at the same time firms are setting prices, so that both firms and policymakers have the same information. (b) The central bank determines monetary policy after firms have set prices using information not available at the time prices were set. 3. An economy is initially in equilibrium at the natural level. The central bank increases the money supply. Graphically illustrate and explain short-run monetary non-neutrality and long-run monetary neutrality using the AD AS model. 4. Suppose that an economy has the Philips curve π = π 1 0.5(u u ) and that the natural rate of unemployment is given by an average of the past two years unemployment: u = u 1 + u 2 2 (a) Why might the natural rate of unemployment depend on recent unemployment (as is in the preceding equation)? (Hint: You may wish to refer to the explanation of hysteresis.) (b) Suppose that the Federal Reserve follows a policy to reduce permanently the inflation rate by 1 percentage point. What effect will that policy have on the unemployment rate over time? (c) What is the sacrifice ratio in this economy? Explain. (d) What do these equations imply about the short-run and long-run tradeoffs between inflation and unemployment? 3 SOLUTIONS Multiple Choices: 1 5 D C B A C 6-11 A C C A B B Short Answers and Numerical Problems 4

5 1. The economy has the Phillips curve: π = π 1 0.5(u 0.06) (a) The natural rate of unemployment is the rate at which the inflation rate does not deviate from the expected inflation rate. Here, the expected inflation rate is just last period s actual inflation rate. Setting the inflation rate equal to last period s inflation rate, that is, π = π 1, we find that u = Thus, the natural rate of unemployment is 6 percent. (b) In the short run (that is, in a single period) the expected inflation rate is fixed at the level of inflation in the previous period, π 1. Hence, the short-run relationship between inflation and unemployment is just the graph of the Phillips curve: it has a slope of 0.5, and it passes through the point where π = π 1 and u = This is shown in Figure 1. In the long run, expected inflation equals actual inflation, so that π = π 1, and output and unemployment equal their natural rates. The long-run Phillips curve thus is vertical at an unemployment rate of 6 percent. Figure 1: Philips Curve (c) To reduce inflation, the Phillips curve tells us that unemployment must be above its natural rate of 6 percent for some period of time. We can write the Phillips curve in the form π π 1 = 0.5(u 0.06) Since we want inflation to fall by 5 percentage points, we want π π 1 = Plugging this into the left-hand side of the above equation, we find 0.05 = 0.5(u 0.06). We can now solve this for u: u =

6 Hence, we need 10 percentage points of cyclical unemployment above the natural rate of 6 percent. Okunąŕs law says that a change of 1 percentage point in unemployment translates into a change of 2 percentage points in GDP. Hence, an increase in unemployment of 10 percentage points corresponds to a fall in output of 20 percentage points. The sacrifice ratio is the percentage of a year s GDP that must be forgone to reduce inflation by 1 percentage point. Dividing the 20 percentage-point decrease in GDP by the 5 percentage-point decrease in inflation, we find that the sacrifice ratio is 20/5 = 4. (d) One scenario is to have very high unemployment for a short period of time. For example, we could have 16 percent unemployment for a single year. Alternatively, we could have a small amount of cyclical unemployment spread out over a long period of time. For example, we could have 8 percent unemployment for 5 years. Both of these plans would bring the inflation rate down from 10 percent to 5 percent, although at different speeds. 2. (a) The aggregate supply curve implies that the central bank can only cause output to deviate from the natural level and have an impact on real variables if it can change (P P). Therefore, only unexpected changes in monetary policy can change output. If firms have access to all information when they form expectations, then they have already taken into account the anticipated effect of monetary policy, and the expected monetary policy cannot have real effects on the economy. (b) If the central bank sets monetary policy after all firms have formed expectations, then monetary policy can have real effects on the economy by changing the price level. As a result the actual price level will deviate from the expected price level, which was already set, and the level of output will deviate from the natural level, a real change in the economy. Figure 2: AD AS Curve 3. Refer to Figure 2. Monetary nonneutrality occurs when changes in money affect real variables. Graphically, this is shown in the short run as the economy moves from A to B. The increase in money increases output, a real variable. This occurs because firms and workers are expecting price level P 1, but the price level rises to P 2. Eventually, workers expectations of the price level increase, shifting the AS curve up. 6

7 Monetary neutrality occurs when changes in money affect only nominal variables, not real variables. Graphically, this is depicted in the long run as the economy eventually moves from A to C. The increase in money affects only prices. 4. In this model, the natural rate of unemployment is an average of the unemployment rates in the past two years. Hence, if a recession raises the unemployment rate in some year, then the natural rate of unemployment rises as well. This means that the model exhibits hysteresis: short-term cyclical unemployment affects the long-term natural rate of unemployment. (a) The natural rate of unemployment might depend on recent unemployment for at least two reasons, suggested by the theory of hysteresis. First, recent unemployment rates might affect the level of frictional unemployment. Unemployed workers lose job skills and find it harder to get jobs; also, unemployed workers might lose some of their desire to work, and hence search less hard for a job. Second, recent unemployment rates might affect the level of structural unemployment. If labor negotiations give a greater voice to insiders than outsiders, then the insiders might push for high wages at the expense of jobs. This will be especially true in industries in which negotiations take place between firms and unions. (b) If the Fed seeks to reduce inflation permanently by 1 percentage point, then the Phillips curve tells us that in the first period we require or π 1 π 0 = 1 = 0.5(u 1 u n 1 ) (u 1 u n 1 ) = 2 That is, we require an unemployment rate 2 percentage points above the original natural rate u. Next period, however, the natural rate will rise as a result of the cyclical unemployment. The new natural rate u will be u = 0.5[u 1 + u 0 ] = 0.5[(u n 1 + 2) + u n 1 ] = u n Hence, the natural rate of unemployment rises by 1 percentage point. If the Fed wants to keep inflation at its new level, then unemployment in period 2 must equal the new natural rate u. Hence, u 2 = u n In every subsequent period, it remains true that the unemployment rate must equal the natural rate. This natural rate never returns to its original level: we can show this by deriving the sequence of unemployment rates: u 3 = (1/2)u 2 + (1/2)u 1 = u u 4 = (1/2)u 3 + (1/2)u 2 = u u 5 = (1/2)u 4 + (1/2)u 3 = u

8 Unemployment always remains above its original natural rate. In fact, we can show that it is always at least 1 percent above its original natural rate. Thus, to reduce inflation by 1 percentage point, unemployment rises above its original level by 2 percentage points in the first year, and by 1 or more percentage points in every year after that. (c) Because unemployment is always higher than it started, output is always lower than it would have been. Hence, the sacrifice ratio is infinite. (d) Without hysteresis, we found that there was a short-run tradeoff but no long-run tradeoff between inflation and unemployment. With hysteresis, we find that there is a long-run tradeoff between inflation and unemployment: to reduce inflation, unemployment must rise permanently. 8