Consider an economy described by a Phillips curve, Tt = t_1+rt to, where > 0 is...
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Consider an economy described by a Phillips curve, Tt = t_1+rật to, where > 0 is a parameter and ŷt is the output gap: the log deviation of output in the Keynesian model from its level in the Classical model. In addition, we have an IS curve that says ŷt = ŷt+1 (rt-rt), where r is the natural interest rate. Finally we assume that monetary policy sets rt = rf +ŷt+1+m(πt - π) - at, where m > 0 is a parameter, is the Fed's inflation target and at is a monetary policy shock. 1. Explain how we have derived the IS curve from the Euler equation in the previous problem. Derive the aggregate demand curve, an equation relating the output gap to inflation. Explain how the slope of this curve changes when m increases. What does m capture? 2. In steady state ot = at = 0. Find the level of inflation and the output gap in the steady state. 3. Suppose that in 2016 the economy is in a steady state and that m = ∞. Discuss the effect of a temporary increase in ot (in 2017 only) on inflation and the output gap in 2017 and the next 2 few periods. Use the AD/AS diagram to explain your answer. Show the transition dynamics of the output gap and inflation in a separate graph. (You do not have enough information here to be able to provide an exact numerical answer - simply provide a qualitative explanation for what happens. If the behavior of some variable is ambiguous, please explain why.) 4. Suppose the discount factor 3 increases in this economy. How should the Fed react if it wants to achieve a 0 output gap and constant rate of inflation? Suppose instead that the Fed leaves the interest rate unchanged. Explain what happens to the output gap and inflation in the period of the shock and in the next few periods. (You do not have enough information here to be able to provide an exact numerical answer - simply provide a qualitative explanation for what happens.) A transition graph that shows the dynamics of output and inflation would be very valuable here. Consider an economy described by a Phillips curve, Tt = t_1+rật to, where > 0 is a parameter and ŷt is the output gap: the log deviation of output in the Keynesian model from its level in the Classical model. In addition, we have an IS curve that says ŷt = ŷt+1 (rt-rt), where r is the natural interest rate. Finally we assume that monetary policy sets rt = rf +ŷt+1+m(πt - π) - at, where m > 0 is a parameter, is the Fed's inflation target and at is a monetary policy shock. 1. Explain how we have derived the IS curve from the Euler equation in the previous problem. Derive the aggregate demand curve, an equation relating the output gap to inflation. Explain how the slope of this curve changes when m increases. What does m capture? 2. In steady state ot = at = 0. Find the level of inflation and the output gap in the steady state. 3. Suppose that in 2016 the economy is in a steady state and that m = ∞. Discuss the effect of a temporary increase in ot (in 2017 only) on inflation and the output gap in 2017 and the next 2 few periods. Use the AD/AS diagram to explain your answer. Show the transition dynamics of the output gap and inflation in a separate graph. (You do not have enough information here to be able to provide an exact numerical answer - simply provide a qualitative explanation for what happens. If the behavior of some variable is ambiguous, please explain why.) 4. Suppose the discount factor 3 increases in this economy. How should the Fed react if it wants to achieve a 0 output gap and constant rate of inflation? Suppose instead that the Fed leaves the interest rate unchanged. Explain what happens to the output gap and inflation in the period of the shock and in the next few periods. (You do not have enough information here to be able to provide an exact numerical answer - simply provide a qualitative explanation for what happens.) A transition graph that shows the dynamics of output and inflation would be very valuable here.
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The Phillips curve is an economic concept that describes the inverse relationship between unemployment and inflation in an economy In the short run when unemployment is high there is little pressure o... View the full answer
Related Book For
Macroeconomics
ISBN: 978-1464168505
5th Canadian Edition
Authors: N. Gregory Mankiw, William M. Scarth
Posted Date:
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