Econ 2HH3 Quiz #2

February 10, 2014

Solution
Problem Section: [25 marks]
Question #1: [5 marks]
Assume that in a certain economy, the LM curve is given by the following equation:
Y = 2(M/P) + 20r + u, where u is random shock that is equal to + 50 half the time and
50 half the time. Assume that the price level (P) is fixed at 1.0. The natural rate of
output is 180.
The IS equation is Y = 300 30r and assume that there are no random shocks in IS.
The central bank wants to keep output (Y) stable at 180. Consider two policy rules:
(i) Set money supply (M) equal to 50 and keep it there or
(ii) Adjust money supply (M) to keep interest rate constant at 4.
(a)
Consider fixed money supply rule.
What will be Y when u = + 50?
Y = 210
What will be Y when u = - 50?
Y = 150
(b)
Consider fixed interest rate rule of keeping r at 4 percent.
What will be Y when u = + 50?
Y = 180
What will be Y when u = - 50?
Y = 180
(c)
Which rule will keep output closer or equal to 180? Fixed interest rate rule
Question #2:[13 marks]
The AD function is Y = 700 + M/P
The short-run aggregate supply (SRAS) function is Y = YF + 500(P EP).
YF =Full-employment GDP = 1000
Initial money supply (M) = 400
In the long-run, price-surprise (gap between P and expected price) is zero
(a)
Initial long-run equilibrium P = 1.33 EP = 1.33
Y =1000
(b)
Consider an unanticipated increase in M by 100. In other words, M = 500
You need this formula

b b 2 4ac
2a

to solve P

1000 + 500(P 1.33) = 700 + 500/P

1000 + 500P 665 700 500/P = 0
500P 365 500/P = 0
500P2 365P 500 = 0
a = 500
b = - 365
c = - 500
P = [365 + (133225+1000000)0.5]/1000 = 1429.53/1000 = 1.43
The short-run equilibrium P = 1.43 EP = 1.33
Y = 1050
(c)
New long-run equilibrium P = 1.67 EP = 1.67
Y = 1000
(d)
Show your results graphically.
[4 marks]

Question #3: [7 marks]

Consider the following equations in a given economy.
Yt = YPt - (t *t)/ [1+ Y] + t/[1+ Y]
Note that the full-employment (potential) Y is YPt.
t = t-1 + (Yt YPt) + Vt
a.

[DAD]
[DAS]

Assume that the economy is in a long-run equilibrium, depicted by point A in the

graph below. At point A, * = t-1 = t-2, etc. for several periods. Starting at point A,
suppose there is a demand shock (increase in taxes) in period t, which will last for
two periods.
(i)
Draw the new DADt in the diagram below.
As a result, output has increased/decreased (circle the correct choice) and
inflation has increased/decreased (circle the correct choice). [2 marks]
(ii)
What will be the location of DASt+1 in the diagram below?
What will be the location of DASt+1? Show the equilibrium point C.
As a result, output has increased/decreased (circle the correct choice) and
inflation has increased/decreased (circle the correct choice). [2 marks]

Inflation

DASt-1= DASt

t*

DADt-1
Y all

c.
d.

What will be the location of DASt+2? Show the equilibrium point D. [1 mark]
What will be the location of DAD after two periods after the expiry of the demand
shock? What will be the final equilibrium point? [2 marks]

True/False Questions: (75 marks) Bubble a if true and bubble b if false.

Answer Questions #1-2 on the basis of Phillips curve equation and Okuns Law
equation
= e - 0.5[u un] + v
u = un 0.5[GDP GAP]
[Okuns Law]
= inflation rate
e = Expected inflation
u = unemployment rate
un = natural rate of unemployment = 6 percent
v = supply shocks (for example, higher energy costs)
1.

If inflation is one percent, then the short-run unemployment rate will be 4 percent.
If deflation is one percent, then the short-run unemployment rate will be 8
percent.

2.

Disinflation of one percent will lead to loss of GDP by four percent. In other
words, sacrifice ratio is 4. According to Lucas critique, sacrifice ratio is overmagnified. Sacrifice ratio will be zero, if policies to fight inflation are credible
and fully anticipated.

3.

The inside lag is the time between a shock to the economy and the policy action
responding to the shock. Both fiscal and monetary policy have relatively long
inside lags.

4.

Under fixed money-supply growth rate, there is no benefit in having inflation.

Therefore, the optimal rule is zero inflation.
Answer Question #5 on the basis of the following Loss or Misery function of the
Bank of Canada is:
L(u, ) = un ( e) + 2

5.

The first derivative of L with respect to is:

dL/d = - + 2 = 0
[Rule for minima]
Therefore = /2
Higher the dis-taste (), lower is the optimal .

6.

The Phillips curve shifts upward when adverse supply shock, for example, higher
prices of raw-materials (due to poor harvests), occurs.

7.

Consider the short-run aggregate supply of Y=YF + 500(P EP), where Y is the
actual output, YF is the potential output, P is the actual price and EP is the
expected price. The output will be at the natural rate when actual price level (P) is
equal to expected price level (EP). The slope of SRAS curve is 500.

8.

According to the Phillips curve in chapter 14, inflation rate depends on the
following:
Previously expected inflation
An exogenous supply shocks
Deviation of output from natural rate

9.

Inflation target (*) is an exogenous variable in dynamic aggregate demand

(DAD) equation. The DAD curve will shift down, if the inflation target (*)
decreases; as a result, the new long-run equilibrium point will be at a lower * and
lower long-run equilibrium Y.

10.

The AD curve in Chapter 13 is drawn with P in the vertical axis and Y in the
horizontal axis. The AD curve is drawn in Chapter 14 with in the vertical axis
and Y in the horizontal axis. Both AD curves explain the effects of lower r on
investment. Both AD curves use Taylors rule.

11.

Expected price (EP) (which depends on previous years price) is a lagged variable
in SRAS function of Chapter 13

12.

In Chapter 14, short-run equilibrium determines Yt and t. In subsequent period

(t+1), this inflation rate becomes lagged inflation rate that influences the position
of the DAS curve.

13.

Consider long-run equilibrium with DAD and DAS, where it = rt + *t

In the long-run, we will also observe that nominal interest rate is equal to real
interest rate at the natural full-employment GDP.

14.

The dynamic aggregate demand (DAD) equation uses Fisher equation (with i, r
and ) and adaptive expectation.

15.

The equation of nominal rate (i) = + 2.0 + 0.5( -2.0) + 0.5(GDP gap) is the
central bank policy rule equation.
If is 4 percent and the GDP gap is 2 percent, the central bank should set nominal
rate at 8 percent.

16.

Favourable supply shocks (lower V) shift the DAS curve to the right. As a result,
short-run equilibrium decreases, but long-run equilibrium remains unchanged

17.

Assume that the Bank of Canadas target unemployment rate is 6 percent and its
monetary policy is based on adjustment of money supply (M). The Bank of
Canada will increase money supply (M) whenever actual unemployment rate
exceeds target unemployment rate

18.

There will be a leftward of the DAS curve in year t if there was inflation in the
previous year. In the dynamic model of DAD/DAS, one period of time is
connected with next period of time through inflation expectations.

19.

Proponents of real business cycle theory assume that the most fluctuations of
output represent changes in the natural rate of output.

20.

Monetarists favour counter-cyclical fiscal policy to fight recession

21.

The slope of the DAD curve = /Yt = -(1+ Y)/

22.

Higher the estimate of , flatter is the DAD curve.

If DAD curve is relatively flat, then supply shocks (shifts of DAS curve) will
bring relatively larger changes in Y.

Answer Questions #23-25 on the basis of central banks response function outlined
below.
it = t + rnt + 0.5(t - *t) + 0.5(GDP Gap)
Assume that central banks inflation target is 2 percent
Real natural rate of interest at (full-employment) potential YP is 2 percent.
23.

Assume that V increases and increases to 3 and GDP gap becomes 0.5.
Short-run equilibrium solutions are:
Nominal interest rate (i) = 5.25
=3
Real interest rate = 2.25
Long-run equilibrium solutions:
Nominal interest rate (i) = 4
=2
Real interest rate = 2

24.

Suppose the central bank reduces the inflation target to 1 percent.

Long-run equilibrium solutions:
Nominal interest rate (i) = 3
=1
Real interest rate = 2

25.

Consider a favourable one year increase in G due to temporary fiscal stimulus and
a rightward shift of the DAD curve
Short-run equilibrium will be higher than * and Y will be higher than YP.
Once the fiscal stimulus discontinued, there will be a leftward shift of the DAD
curve and Y will fall short of YP. Central bank policy rule kicks in and finally
decreases to * and Y settles at YP.

Solution of Regular Quiz #2 Econ 2HH3

=B
1. A
2. A
3. B
4. A
5. A
6. A
7. B
8. A
9. B
10. B
11.
12.
13.
14.
15.

A
A
A
A
A

16.
17.
18.
19.
20.

A
A
A
A
B

21.
22.
23.
24.
25.

A
A
A
A
A

Feb 10, 2014 True = A

False