Question 4 (10 marks)

An election is looming in the country of Atlantis, where the level of output is based on the following equation:

Y_t = Y* +P_t - EP_t

Where t is a generic year, Y is the level of output, P is the price level, EP is the rational expectation of the price level and Y* is the full employment equilibrium level of output.

You work for the Finance Ministry and your Director-General wishes to plan for the most likely scenario regarding the price level and output post-election. As an applied macroeconomist with a knowledge of Political Economy, you have been tasked to lead a team on estimating the price level and output level based on two scenarios, the first where the Workers Party wins, and the second scenario where the Liberal Democratic Party wins.

Elections are held at the end of year t, so that a new government is in office for years t = 1 and t = 2. The election is contended by many parties but only the two parties above stand any chance of forming government in a winner-takes-all system. The Workers Party is always promising greater economic growth whatever the consequences and hence will tolerate higher inflation, with a preferred price level of 110. Their more economically conservative rivals prefer for the price level to sit at 90. Scientific and credible predictions of the election give the Liberal Democratic Party a 60% chance of winning the elections.

1. Given the information above, what is your best estimate of the price level in t = 1 and t = 2? Show your workings and explain your answer. (4 marks)
2. Under which party will the output gap be positively bigger in t=1? Explain your reasoning. (2 marks)
3. Your supervisor also asks you to consider the situation in t=2 when rational expectations are replaced by adaptive expectations in time t=1. Compare and contrast the situation with respect to the output level in time t=2 under both potential administrations. (4 marks)