In the 2001 recession unemployment rose to 6%, which is above the natural rate o
ID: 1206000 • Letter: I
Question
In the 2001 recession unemployment rose to 6%, which is above the natural rate of unemployment of 5%. Suppose a Phillips curve equation: pi_t = (0.5)(u* - u_t-1) + pi^e_t. If expected inflation is 2% then what will wage inflation be? Again consider an unemployment rate of 6%, and a natural rate of 5%. By what percentage was output below potential GDP? If potential GDP is $2.25 trillion by how much would we need to raise GDP to in order to see full employment at 5% again? Suppose that output is $2.31, the natural rate is 4.5%, potential GDP is $2.25, inflation was 3% last year, expectations are adaptive, and the phillips curve equation is What will the inflation rate be this year? Consider the following version of the Phillips curve: nt = nte - 1.25 (u-u*) + v. Suppose that the expectations are 2% and the natural rate is 5.5%. Then the economy is hit by an oil price shock and a financial crisis. The oil price shock embodied an inflation rise of 2 percentage points and inflation turned out to be 1.5%. What effect did the financial crisis have on the unemployment rate? 5. Explain why expansionary monetary policy affects output before it affects inflation. 6. If there is a negative expenditure shock, what will be the effect of countercyclical monetary policy on output and inflation. When will these effects occur if there are time lags. What is the fed's goal in using countercyclical policy?Explanation / Answer
1) The economy has the Phillips curve:
t = (0.5)(u* - ut-1) + et
Given that the unemployement rate is 6%, the natural rate of unemployement is 5% and expected inflation is 2%, plug-in the values:
t = (0.5)(5 - 6) + 2 = 1.5
Hence the wage infkation would fall to 1.5%
2) GDP gap is the difference between actual GDP and potential GDP.
Okun's law predicts a GDP gap of -2% for every 1% that the unemployment rate exceeds its natural rate. For this economy, the GDP gap is (6.0 – 5.0) x -2 = -2%
Hence the GDP is 2% below its potential level.
b) If potential GDP is 2.25 trillion then a 2% of this level, that is 45 billion is the output gap that is needed to be covered, to raise the GDP help it reaching the potebntial level.