Tutorial Sheet 5: The Natural Rate of Interest

Economics 2
University of Edinburgh

Week 6, Fall 2023

Required reading
– Recent lecture notes
– Nils Gottfries, Macroeconomics, Chapter 4
(Note: it is assumed here and will be assumed in the exam that you are familiar with the
terminology laid out on pages xxvi - xxvii of Gottfries’ text.)
– Renshaw Ch. 19
Homework
– Submission of homework this semester works like Econ 1 last year, but there is now one additional
component – you must also submit a graph.
– The submission must be done via Learn by 5pm on the Sunday before the tutorials occur.
– The written homework should be equivalent to at least two sides of handwritten A4 and should be
clear enough to read. It does not need to be complete, and indeed it does not even need to be correct.
You just need to show that you have made an honest attempt. As long as you have shown an honest
attempt, you will get credit, and as long as you do this for 14 of the 18 tutorials during the year, you
will get full credit.
– NEW FOR ECON 2: you must also submit an additional page with a ‘looking at the data’ graph (this
will be different each week, and relevant information will be on each tutorial sheet).
Further resources
– Gottfries on YouTube: the textbook author (Nils Gottfries) has put 15-40 minute videos from most
chapters of the book on YouTube:
– https://goo.gl/Wq8o82
– FRED: Most of the tutorial sheets this semester contain graphs generated by the St. Louis Fed’s Federal
Reserve Economic Data (FRED) site. This is a surprisingly easy-to-use, free site for exploring hundreds
of thousands of economic data series. You are strongly encouraged to visit the site whenever you feel
the need to find out what’s happened lately to GDP growth, or inflation, or infant mortality, etc.
– https://fred.stlouisfed.org/
Recordings:
– For this tutorial, there are no recordings available.

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Looking at the data
Using FRED (or another data source) find and print a graph of inflation over time for a country of your
choice. Include comments on any patterns or features in the data and bring the printed graph and comments
to your tutorial.

Priority Questions
We strongly recommend attempting every question on this tutorial sheet.1 However, if you find yourself
lacking for time and need to prioritize, you should start by focusing on: Q1, Q2, Q4, Q5, Q6, Q7, Q8, Q9,
and Q10

Tutorial Questions
Q1. Analyse how the following shocks will affect the natural rate of interest:
(a) Firms become more pessimistic about future demand for their products.
(b) A hurricane destroys a substantial share of the capital stock but miraculously no one dies.
Q2. Assume that the natural real interest rate is 3%, inflation is 2%, and the central bank sets the nominal
interest rate at 3%. Will production be above or below the natural level? Is this a sustainable situation?
Q3. Transpose the following matrices:
 
1 2 3
a. 4 5 6
7 8 9
 
3 4
b. −1 8
7 9
 
1 2 3
c. 2 5 7
3 7 9
Q4. A factory shuts down where 1,200 people become unemployed and begin a job search. There are two
states, employed (E) and unemployed (U), where the initial vector is:
   
E 0
x0 = =
U 1200

A transition probability matrix is given by:

   
P r(E, E) P r(E, U ) 0.9 0.7
P = =
P r(U, E) P r(U, U ) 0.1 0.3

where, for example Pr(E, U ) = 0.7 is the probability that an unemployed individual finds a job by the
next period.
(a) What will be the number of unemployed people after (i) 2 periods; (ii) 3 periods; (iii) 5 periods; (iv)
10 periods?
(b) What is the steady-state level of unemployment?
1 And you should note that all of the content here is potentially examinable

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Q5. Find the inverses (if they exist) of:
       
1 3 0 4 1 4 1 3
A= ;B= ;C= ;D=
−1 2 3 2 3 12 1 4
Q6. Using matrix inversion, solve the following set of simultaneous equations:

x + 3y = 5

−x + 2y = 2

Q7. The demand and supply functions for apricots and blackberries are as follows:

QD
a = 96 − 4Pa + 2Pb

QSa = −4 + 28Pa

QD
b = 40 + 8Pa − 5Pb

QSb = −4 + 7Pb
(a) By imposing the equilibrium condition that quantity supplied equals quantity demanded in both
markets, find a pair of simultaneous equations in the price variables. Write this in matrix form.
(b) By inverting the coefficient matrix, find the equilibrium prices.
Q8. Find the determinant, all minors and cofactors, and the inverse of each of the following matrices:
       
1 1 −1 2 −1 −1 5 2 −1 10 5 1
A = 2 2 3  ; B = 2 0 3  ; C = 2 −1 4  ; D =  2 −1 4
4 0 0 4 0 4 2 0 2 4 0 4
Q9. Use Cramer’s rule to find x in the system of equations:

y−z =2

3x + 2y + z = 4

5x + 4y = 1

Q10. Solve the following system of linear equations using matrix inversion and Cramer’s rule.
    
2 1 1 x 0
1 1 2 y  = 1
4 3 4 z 0

Q11. Read the following articles:

– https://www.economicsobservatory.com/how-has-inflation-behaved-during-the-pandemic.
– https://www.economicsobservatory.com/how-can-we-measure-consumer-price-inflation-lockdown
Discuss conceptually how CPI is measured and potential problems with measuring CPI during the COVID
lockdown.

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