FIFTH TAKE-HOME EXERCISE SET [12 Points Total] L. Tesfatsion DUE DATE: Thursday, April 11, 9:30 A.M. Econ 302/Spring 96 **PLEASE NOTE: As always, no late assignments will be accepted. Each exercise below concerns a Hall and Taylor Chapter 8 economy satisfying the following six properties UNLESS OTHERWISE SPECIFIED: (1) The economy exists over time periods T=0,1,...; (2) Potential GDP is given by a **constant** value Y* in each period; (3) Money demand is given by M^D/P = kY - hR, implying that the expected inflation rate does **not** affect money demand. (4) At the beginning of period 0 the economy is in internal balance; (5) the actual inflation rate INF(0,1) from period 0 to 1 is zero; (6) The expected inflation rate satisfies (*) INF^e(T,T+1) = 0.6 x INF(T-1,T) , T = 1,2,... . ---------------------------------------------------------- EXERCISE 5.1 [4 Points Total; 2 points for each part]. [HINT: For some parts of this exercise, use the HT6 formula [1 + q^2 + q^3 + ... ] = 1/[1-q], which holds for any number q with absolute value less than 1.] Part (a): Suppose that GDP Y(1) for period 1 rises above the potential GDP level Y*, but that Y(T) = Y* in all subsequent periods T = 2, 3,... . Using the Hall and Taylor expectations-augmented Phillips curve, determine what happens to the **actual** inflation rate over periods T = 2, 3, ... How would your answer change if, in relation (*), the constant 0.6 were changed to 1.5? #Be sure to justify your assertions#. Part (b): Suppose, instead, that GDP Y(1) for period 1 rises to a level Y' that is higher than Y*, and that Y(T) **remains** at the higher level Y' in all subsequent periods T = 2, 3,... Using the Hall and Taylor expectations- augmented Phillips curve, explain what happens to the **actual** inflation rate over periods T = 2, 3, ... How would your answer change if, in relation (*), the constant 0.6 were changed to 1.5? #Be sure to justify your assertions#. ------------------------------------------------------ EXERCISE 5.2 [4 Points Total; 2 points for each part]. Hall and Taylor, Chapter 8, ANALYTICAL exercise 4, page 226-227. #Be sure to justify your assertions and label your graphs carefully#. NOTE: For each part of this exercise, assume that the government increase in defense spending occurs suddenly at the beginning of period 1, disrupting the internal balance of the economy. In the first part, assume [instead of relation (*)] that expectations of inflation remain at zero. In the second part, assume that expectations of inflation satisfy relation (*). -------------------------------------------------------- EXERCISE 5.3 [4 Points Total; 2 points for each part]. Hall and Taylor, Chapter 8, MACROSOLVE exercise 4, page 228. NOTE: For part a, explore at least **three different combinations** of expansionary fiscal policy and tight monetary policy to check the robustness of your policy conclusions. For part b, you might first want to review some of the U.S. data presented by Hall and Taylor in Chapters 1 through 3. --------------------------------------------------------