Question

(18 marks) Suppose that the Phillips curve is given by: TT. = + 0.2 – 5ugs with people’s expectation of inflation governed by: T = 11-14 At time t = 0, it is known that the economy is in a medium run equilibrium with inflation rate of 3%. a. Find the natural rate of unemployment for this economy. (3 marks) b. If starting t = 1, the government decided to keep unemployment rate permanently at 3%. Find the expected inflation and actual inflation to for periods t = 1, t = 2, and t = 3. (4 marks) c. Comment on your findings from b). Are they reasonable to you? Explain. (4 marks) d. If the Phillips curve is plotted in a diagram with the change in inflation over the vertical axis and unemployment over the horizontal axis, are your observations representing a movement along the Phillips curve or is there a shift in the Phillips curve? (3 marks) e. Suppose in t = 4, people modify their expectation rule according to: = 0.51,-1 + 0.5(1,-1-1-e which is the average of latest inflation and the past prediction error (11-1 - 1-1). Will inflation in t = 4 be going up or down from the last period? (4 marks)

Answer 1

cas rit 40.2-5Ut 54 ort=r 0 = 0.2-sut WE - 02 5. -0.04 4010 (6) = 0.03 to 2 - 580.03 6.68 in 8% olta 6.08 +0.2 - 5 X 0.03 0.13 or 113% It3 = 0.13 +0.2-5X0.03 = 18% Inflation will rise in etu enery period is unemployment is kept at 3). forever Inflation will turn into the hyper Inflation which is not reasonable

LRPG (d) F. 18% La LE 131 .B %1. 31. A SRPC. 3. 3.1. 4.1. re = 0.5 X0098 4 0.510.03-0. 0.5(0.03-0042 8.5% there is decline in ethe inflation.