Econ 204 10 points Vamsi V. Assignment 3
I. Philips Curve 5 points Suppose that the Philips curve is given by
πt = πet + 0.1 -2ut
a. What is the natural rate of unemployment?
b. Assume πet = θπt-1
and suppose that θ is equal to 0. Suppose that the 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. Determine the rate of inflation in years t, t+1, t+2, and t+5.
c. Do you believe the answer given in (b)? Why or why not? (Hint: Think about how people are
likely to form expectations of inflation.)
Now suppose that in year t+5, θ increases from 0 to 1. Suppose that the government is still
determined to keep u at 3% forever.
d. Why might θ increase in this way? What will the inflation rate be in years t+5, t+6, and t+7.
e. Do you believe the answer given in (d)? Why or why not? II. Open Economy 5 points Consider an economy where
C=200+0.25(Y-T)
I=150+0.25Y-1000i
G=250, T=200
(M/P)d=2Y-8000i
(M/P)s =1600
X = 0.3Y*, IM =0.2Y,
ε (real exchange rate) = 2, Y* is foreign output (Y*=900) 1 a. Calculate the multiplier if the economy is closed and the multiplier if the economy opens up.
Explain the economic intuition why two are different with 3-5 sentences.
b. Solve for the equilibrium level of income (Y) for the open economy (Yopen) and calculate the
trade balance (NX).
c. Solve for the equilibrium level of interest rate for the open economy (iopen).
d. If government follows an expansionary fiscal policy and G changes by 60, calculate the
change in Y for both the closed economy (∆Yclosed) the open economy (∆Yopen). Assume no
change in the foreign output (Y*), Calculate the new trade balance.
e. If this economy has flexible exchange rate regime, how would the exchange rate respond to a
fiscal expansion policy? Appreciation or Depreciation? Explain why. 2