• February 14th, 2017

Question

Paper , Order, or Assignment Requirements

1. For each part of this question, please refer to one of the following concepts in your
answer.
• Intertemporal Substitution of Labour Supply
• Total Factor Productivity
• Aggregate Production Function
• Policy Ineffectiveness Proposition
• Lucas Critique
• Stochastic vs Systematic
18 (a) (1 A4, both sides)
Consider an economy where the following occurs:
• In even-numbered years, the money supply does not change
• In odd-numbered years, the money supply increases by 10%.
Perhaps surprisingly, output does not vary from year to year, it remains constant.
Unemployment does not vary from year to year, either.
As for inflation:
• In even-numbered years, inflation is 0%
• In odd-numbered years, inflation is 10%
Illustrate a graph of aggregate supply and aggregate demand to show
how the observed behavior of output and unemployment occurs when
the economy switches from an even-numbered year to an odd-numbered
year.
Explain how and why this outcome occurs.
12 (b) (1 A4, one side only)
In the same economy as above, in the year t (an odd-numbered year), the money
printing press catches fire, and there is no change in the money supply. However,
no one notices this until the end of the year.
Which of the following is the most likely rate of inflation in year t:
0%, 10%, or something between the two?
Which of the following is the most likely value of output in year t:
the usual level of output, more output than usual, or less output than
usual?
Explain why this result differs from the outcome in an even-numbered
year. If it does not, why not?
Page 2
2. For this question, consider the DAD-DAS framework of the macroeconomy. The
following equations hold throughout the parts of the question.
IS Curve: Yt = Y¯ + (2 − rt) + mt + t
Aggregate Supply: πt = π
e
t + (Yt − Y¯ ) + νt
Taylor Rule: it = (πt + 2) + φπ(πt − π

) + φY (Yt − Y¯ )
Fisher Equation: it = rt + π
e
t+1
Variable/Parameter Description
Yt Output at time t
Y¯ Natural level of output
rt Real interest rate at time t
mt Shock to the money supply
t Demand shock
πt Rate of inflation at time t
π
e
t Expected inflation for time t
νt Supply shock
it Nominal interest rate
π

Inflation target (constant over time)
φY Monetary policy parameter, positive
φπ Monetary policy parameter, positive
The variables are described in the table above. The three shock terms, mt
, t
, and
νt
, are stochastic and uncorrelated, with expected value of zero. Consider mt to be
an arbitrary deviation from the intended monetary policy.
25 (a) (3 A4 sheets, both sides)
Suppose initially that π
e
t = πt−1, so that expectations are adaptive.
Solve for the equilibrium output and inflation at time t.
Find the long run equilibrium output and inflation, and the long run
real interest rate.
Page 3
20 (b) (2 A4, front and back)
Suppose initially that the Taylor rule is targeted for an inflation goal of 4%,
so that π
∗ = 4. Suppose that at time t − 1, the economy is at the long run
equilibrium.
At time t, the central bank decides instead to target an inflation rate of 2%, so
that π
∗ = 2.
Complete the following table to indicate whether each of the variables
increases, decreases, or stays the same relative to their values before
the policy change.
Yt πt rt
Short Run
Long Run
Illustrate your answer with a graph of the DAD-DAS model. Your
graph should include the old equilibrium (period t − 1), the short run
(period t), and the long run (well after period t).
15 (c) (2 A4 sheets, both sides)
Suppose instead that consumers have rational expectations. Consider again the
change in policy from the previous part of the question, lowering the inflation
target from 4% to 2%. In particular, assume that the central bank announced
the policy change.
Complete the following table to indicate whether each of the variables
increases, decreases, or stays the same relative to their values before
the policy change.
Yt πt rt
Short Run
Long Run
Illustrate your answer with a similar graph to the previous part of the
question.
10 (d) (1 A4 sheet, one side)
Which of the two types of expectations (adaptive or rational) yields
higher output?
Name one policy that the government can follow to help make expectations
fit your answer (that is to say, name a policy that can help
make expectations adaptive or rational, whichever was your answer).
Briefly explain why.

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