Subject: Economics / General Economics
Problem Set #5
ECN 101 Winter 2017 ModjtahediQuestion 1:
The following model is what you have seen earlier in the class (Same as Problem Sets 3 and 4
and the corresponding solution keys). Assume that the price level is endogenous. Assume also
that wages and prices are fully flexible in the long run but sticky in the short run. = Goods market equilibrium = + + ? Aggregate demand = ? + Consumption function ???? = ? + Disposable income = Tax function = ? ? 100 Investment function ? = 180,000 Supply of nominal balances = 0.20 ? 60 Demand for real balances Economists have estimated that: ? = 1700 ? = 3,500 ???? = 1,000 ? = 1,000 = 0.80 = 0.375 The macroeconomic model above pertains to a country called Nowheria that is governed by a cruel
dictator. This despot has been conducting massive expansionary monetary policies to pay for the
roads and bridges he was building, not to mention the enormous military buildup he was seeking.
Because of these past irresponsible policies, the country is suffering from a very high inflation
rate. The main goal of this dictator was for you to have some relatively nice numbers in this
homework. Assume that the potential level of GDP equals Y* = 12,900 and the natural rate of
unemployment is u* = 5%.
The aggregate demand equation that comes out of the above model is what people were expecting
to materialize this year (ADe). Therefore, people were expecting the general price level this year
to be Pe = 80 as in PS#4 and the real GDP to equal Y* = 12,900. Last year, the price level was P
= 50 so that last year people were expecting the inflation rate for this year to be 60% (horrible!)
The short-run supply function for Nowheria is of the form: Page 1 of 2 ? = 0.50 × ( ? ? )
a. The economic advisors warn the dictator of the consequences of the high inflation rates
and, as a result, he decides to bring it under control. Therefore, this year, he unexpectedly
reduces the money supply by 25%. Find the short-run price and GDP levels for this year.
Show the situation in a nice AD-AS-SRAS graph.
b. Some cool economists have estimated that the relationship between unemployment rate
and the percentage GDP gap is of the following form: ? ? = ?3.25 × ( ? ?
? Find the overall and cyclical rates of unemployment for this year.Question 2:
Assume that the Phillips Curve is of the form:
? = ? ? ( ? ? )
Where = 1 and u* = 5%. The Fed has been increasing the supply of money at a rate of m = 2%
a. If no demand or supply shocks hit the economy, what will be the inflation and
b. Suppose that starting from this year, the Fed increases the supply of money at a rate of m
= 6% per year. What will be the long-run inflation and unemployment rates?
c. Suppose that starting from this year, the Fed increases the supply of money at a rate of m
= 6% per year. Which of the following combinations of inflation and unemployment rates
is the plausible short-run result? = 2% & ? = 4% = 3% & ? = 4% = 3% & ? = 5% = 4% & ? = 2% Show parts b and c in a nice Phillips Diagram (with the correct short run numbers from the
list above). Page 2 of 2