# 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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