Economics 14.

02
Problem Set 4
Due Date: 3/31/04
Please STAPLE all sheets together.

Answer each as True, False or Uncertain. Give a two or three sentence explanation
for your answer.

1. Indexing salaries to inflation results in a flatter Phillips Curve because part of the
inflation change is absorbed within the year rather than keeping adjustment bottled-up
until the following year. False – Wage indexation increases the effect of
unemployment on inflation, resulting in a steeper Phillip’s Curve. Without wage
indexation, lower unemployment increases wages, which in turn increases prices.
But because, wages do not respond to prices right away, there is no further effect
within the year. With wage indexation, however, an increase in prices leads to a
further increase in wages within the year, which leads to a further increase in prices,
and so on, so that the effect of unemployment on inflation within the year is higher.

2. The Phillip’s Curve shows that the natural rate of unemployment depends on the
natural rate of inflation (set by long-term commitments of the Federal Reserve
Board). False – The natural unemployment rate is defined where inflation rate is
equal to expected inflation rate; it is the rate of unemployment that keeps the inflation
rate constant. Note, however, that the natural unemployment rate is independent of
the actual value of the expected inflation rate; its level instead is determined by the
mark-up of firms, the structure of the labor market, and the sensitivity of changes in
the inflation rate to the unemployment level (see equation 8-8).

3. The natural unemployment rate decreased in both Europe and the United States over
the last thirty years because of the competitive pressures to which globalization
exposed firms. False – The facts are wrong, but the theoretical contribution of
globalization is correct. First, while the United States saw a decrease in the natural
unemployment rate in the 1990s (perhaps in part due to globalization) the natural
unemployment rate was higher in the late 1970s and 1980s than in the 1950s and
1960s (not a thirty-year decline). The natural unemployment rate in Europe is now
5% higher than it was in the 1960s. However, globalization should foster stronger
competition between firms internationally (a decrease in the mark-up) and strengthen
firm bargaining power due to outsourcing (a decrease in our labor market variable
z); both of these forces should push down the natural unemployment rate.

4. The impact of output fluctuations for employment levels are diminished because
some of the new workers are drawn from individuals previously classified as out-of-
the-labor-force. False – Our fully specified Okun’s law estimates growth above
normal growth (i.e., growth in excess of population expansion and productivity
increases) results in a 0.4 decrease in unemployment rate. One reason for the
smaller coefficient comes from our definition of unemployment. An employment
increase due to output growth partially draws from the unemployed as well as those
not previously looking for work. Thus, a 0.6% increase in employment only leads to a
 0.4% decrease in unemployment as some workers are pulled from those outside of the
labor force, and some discouraged workers may resume the job search process and
thus be counted again as unemployed. [Other reasons for the 0.4 coefficient are
labor hoarding by firms and that some workers’ jobs are not output linked – see page
184.] So the effect in the question can lead to a diminished effect on the
unemployment rate (compared to the case where all hired workers come from within
the labor force).

5. The speed at which the Federal Reserve Board undertakes dis-inflation affects the
cumulative unemployment response the economy experiences. Uncertain –
Theoretically, this depend on how expectations are formed. The basic model of
expected inflation being equal to last year’s inflation suggests the cumulative
unemployment effects are independent of whether the dis-inflation is undertaken in
one year or spread out over several years. But in the models of Lucas and Sargent, a
fully-credible central bank could change the inflation rate with no adverse response.
In fact, a faster dis-inflation might be better for maintaining credibility. Fisher and
Taylor argued, however, that the presence of nominal rigidities and contracts (i.e.,
staggering of wage decisions) make it important for dis-inflation to be managed over
several years even if expectations did adjust. Empirically, some evidence does
suggest that faster dis-inflations result in smaller sacrifice ratios.
Longer Problems:

1. (Chapter 8) Please use the table below to organize your responses for parts b and e.
You should show your work however so that partial credit can be given.
Year T T+1 T+2 T+3 T+4 T+5 T+6 T+7
Πt 4% 4% 4% 4% 4% 8% 12% 16%

Suppose the Phillips Curve is given by [Πt is the inflation rate, EΠt is the expected
inflation rate, and ut is the unemployment rate]:
Πt = EΠt + 0.1 – 2ut
Where
EΠt = ΘΠt-1
Also, suppose Θ is initially equal to zero.
a. What is the natural rate of unemployment? The natural rate is where Πt = EΠt so
that ut=0.1/2=5%.
Suppose that the actual rate of unemployment is initially equal to the natural rate. In
year T, the authorities decide to bring the unemployment rate down to 3% and hold it
there forever.

b. Determine the inflation rate in years T, T+1, T+2, T+3, and T+4. As EΠt=0, a 3%
unemployment rate would require inflation of Πt = 0.1 – 2(.03) = 4% in every
year beginning in T.

c. How long does it take the natural rate of unemployment to decline to 3%? The
natural rate of unemployment never declines to 3%! It is defined to be where Πt
= EΠt and thus remains at 5%.

d. Do you believe your answer to part b? Why or why not? Think about how
people are likely to form their expectations of inflation. EΠt=0 and Πt=4% in
every year. People will not be wrong forever (the Friedman criticism).

Suppose now that in year T+5 the value of Θ increases from 0 to 1. Suppose that the
government is still determined to keep u at 3% forever.

e. What expectations formation does Θ=1 represent? Why might increase this
way? When Θ=1, people expect inflation this year to be what it was last year.
These expectations are likely to form when inflation shows a strong correlation
between years (e.g., the United States’ recent experience).

f. What will be the inflation rates in years T+5, T+6, T+7? The inflation rate must
continually rise to keep unemployment at 3%:

T+5: Π5= Π4+0.1-2(0.03)=8%

 T+6: Π6= Π5+0.1-2(0.03)=12%

T+7: Π7= Π6+0.1-2(0.03)=16%

g. How does the natural rate of unemployment depend on Θ? Again, the natural
rate of unemployment is when EΠt=Πt so that the natural rate is independent of
Θ.

h. Do you believe the answer in e? Why or why not. The scenario described is
unlikely. With Θ=1 inflation expectations are again forever wrong.
2. (Chapter 9) Suppose the economy can be described by the following three equations:

ut – ut-1 = -0.4*(gyt – 3%) Okun’s Law

Πt - Πt-1 = - (ut – 5%) Phillip’s Curve
gyt = gmt - Πt Aggregate Demand
a. What is the natural rate of unemployment? The natural rate is where Πt = Πt-1
(i.e., inflation is not increasing) so that ut=5%.
b. Suppose the unemployment rate has been equal to the natural rate for the last two
periods, and the inflation rate is 8%. What is the growth rate of output? What is
the growth rate of the money supply? When unemployment remains constant, the
Okun’s Law relationship demonstrates output growth must be at its natural level,
or gyt=3%. Rearranging the aggregate demand relationship shows that monetary
growth must be 11%, as gmt=gyt+ Πt=3%+8%=11%.
c. Suppose that the conditions are as in b), when in year T the authorities use
monetary policy to reduce the inflation rate to 4% in year T and keep it there
forever. What must happen to the unemployment rate in year T and thereafter?
What must happen to the rate of grow of output in year T and thereafter? What
must be the rate of nominal money growth in year T and thereafter? Use the
following table to organize your answers.
Πt ut gyt gmt
Year T-1 8% 5% 3% 11%
Year T 4% 9% -7% -3%
Year T+1 4% 5% 13% 17%
Year T+2 4% 5% 3% 7%

The first column is determined by the authorities. The Phillip’s Curve relationship
determines the second column – when the inflation is reduced in year T,
unemployment must rise. Thereafter, the inflation rate is constant so that
unemployment returns to and remains at its natural rate. Re-arranging Okun’s Law
relationship translates the unemployment fluctuations into output growth rate
fluctuations
gyt = 3% + (ut-1 – ut)/0.4

A deep, one-year recession followed by a strong recovery is experienced. Finally, the

Aggregate Demand relationship determines the money supply growth. Note the
surprising result that money growth is actually at its highest in Year T+1.