1 Consider an economy in long-run equilibrium with an inflation rate, It, of 12% (0.12) per year and a natural unemployment rate, u, of 6% (0.06). The expectationsaugmented Phillips curve is It = Jt' - 2(u - u). Assume that Okun's law holds so that a 1 percentage point increase in the unemployment rate maintained for one year reduces GOP by 2% of fuJI-employment output.

a. Consider a two-year disinflation. In the first year It = 0.04 and 1t' = 0.08. In the second year IT = 0.04 and 1t' = 0.04. In the first year, what is the unemployment rate? related to unemployment, u, only if the expected inflation rate, It ' , and the natural unemployment rate, IT, are constant. Changes in the expected inflation rate or in the natural unemployment rate cause the relationship between inflation and unemployment-the traditional Phillips curve-to shift. • Why is the natural unemployment rate an important economic variable? What factors explain the changes in the natural rate over time in the United States? What government policies, if any, might be used to reduce the natural unemployment rate? Give two costs of anticipated inflation and two costs of unanticipated inflation. How is the magnitude of each affected if, instead of a moderate inflation, hyperinflation occurs? What is the greatest potential cost associated with disinflation? How does the responsiveness of the public's inflation expectations affect the size of this potential cost? 9. Discuss at least two strategies for red ucing expected inflation rapidly. What are the pros and cons of these strategies? 10. Why does the Federal Reserve work hard to establish its credibility? What benefits might the public gain if the Federal Reserve has a great deal of credibility? By what percentage does output fall short of fullemployment output? In the second year, what is the unemployment rate? By what percentage does output fall short of full-employment output? What is the sacrifice ratio for this disinflation?

b. Now consider a four-year disinflation according to the following table: Year IT Jt' 1 0.08 0.10 2 0.04 0.08 3 0.04 0.06 4 0.04 0.04 What is the unemployment rate in each of the four years? By what percentage does output faJl short of full-employment output each year? What is the sacrifice ratio for this disinflation?