In one economy, the potential output is 1,000 units, inflation expectations equal 2% and the natural rate of unemployment is  = 4%. The basic relationships in the economy in 

the short-term can be described by the following equations:

Okun's Law:

( )

= , ( )

Philips curve

= , ( )

Calculate by how much GDP must drop for the inflation rate to drop by 1 percentage point (the so-called

sacrifice ratio).2

Consider an economy where the aggregate demand function is given by the following

equation:

= + , +

(

)

and the price adjustment mechanism is described by the function:

= , (

) +

In equilibrium, the price level is 1, investment expenditure is PLN 100 billion, and the nominal money

supply is PLN 180 billion. Calculate what will happen to the economy as a result of the interest rate hike

by the central bank, which will cause a decrease in investment and nominal money supply in equilibrium,

PLN 20 billion each.

a) Calculate inflation, price levels and GDP for the first five years following the tightening of monetary

policy, assuming people expected price stability.

b) Illustrate the mechanism of economic adjustment using the AS-AD model.

c) Perform analogous calculations for 8 years, assuming that inflation expectations are adaptive and

can be expressed as

= 0,41.

d) Describe the process of adjusting the economy to higher interest rates for both scenarios.