MACROECONOMICS ASSIGNMENT-2

5) . Inflation is likely to rise if the monetary authority attempts to

maintain the unemployment rate at its prior level while the economy
is growing. This is so because it is typically believed that the economy
is expanding and there is a high demand for goods and services when
the unemployment rate is low. A rise in inflation may result from this
increased demand driving up costs.
b. Since maintaining price stability is one of the fundamental
objectives of monetary policy, the monetary authority should put
more effort into doing so than aiming to retain the unemployment
rate at its prior level. This can be accomplished by modifying interest
rates and other monetary policy instruments to manage the
economy's money supply.

6) a. The Fisher hypothesis, also known as the Fisher effect, is an

economic theory that suggests that the real interest rate is equal to
the nominal interest rate minus expected inflation. In other words,
the theory states that changes in nominal interest rates should be
equal to changes in expected inflation rates, resulting in a constant
real interest rate.
b. The experience of Latin American countries in the 1990s does not
support the Fisher hypothesis. During this time, many countries in
the region experienced high inflation rates, but nominal interest rates
did not increase as much as expected to compensate for inflation.
This resulted in negative real interest rates, which can lead to
economic distortions and inefficiencies.
c. The Fisher effect does not necessarily suggest that the line drawn
through the scatter of points should go through the origin. The
intercept of the line represents the expected inflation rate, which can
vary depending on a variety of factors such as monetary policy, fiscal
policy, and external shocks. The slope of the line, which represents
the Fisher effect, should remain constant if the hypothesis is true.
d. If the inflation rate is currently 0.25% and the central bank wants
to bring it to 2%, it will take approximately 6.5 years for inflation to
reach that target, assuming a constant rate of inflation. The sacrifice
ratio is the percentage reduction in output that must be endured to
bring down inflation by 1 percentage point. It is different from the
answer in (c) because the sacrifice ratio depends on a variety of
factors such as the structure of the economy, the degree of price and
wage rigidities, and the credibility of monetary policy.
e. If people believe that the central bank is committed to reducing
inflation to 2%, the central bank can let the unemployment rate
return to the natural rate from the year in which people start
believing in the commitment to reduce inflation. The sacrifice ratio
now would depend on the level of unemployment and the degree of
wage and price rigidities in the economy.
f. To lower the rate of inflation by increasing the rate of
unemployment as little and for as short a time period as possible, the
central bank should pursue a credible and consistent monetary policy
that anchors inflation expectations and avoids sudden changes in
policy. Additionally, the central bank should consider using other
policy tools such as fiscal policy, structural reforms, and
communication strategies to mitigate the negative effects of inflation
reduction on output and employment.

7) a. The sacrifice ratio is the percentage increase in the

unemployment rate needed to reduce inflation by 1 percentage
point. In this case, the sacrifice ratio can be calculated by taking the
derivative of the Phillips curve with respect to inflation:
dU/dπ = -β/(1-β) * [(π-πe)/(1+π)]^(1-β)
where U is unemployment, π is inflation, πe is expected inflation, and
β is a parameter. Using the given equations, we can substitute in πe =
πt-1 to get:
dU/dπ = -β/(1-β) * [(πt-πt-1)/(1+πt)]^(1-β)
We can then evaluate this expression at πt-1 = πt = 0.12 to get:
dU/dπ = -2/3
Therefore, the sacrifice ratio is 2/3, meaning that a 1 percentage
point reduction in inflation requires a 2/3 percentage point increase
in the unemployment rate.
b. We know that the central bank will maintain the unemployment
rate 1 percentage point above the natural rate until inflation has
decreased to 2%. Using the Phillips curve equation and the fact that
expected inflation is equal to last year's actual inflation, we can set
up the following recursive equation for inflation:
πt = πt-1 - β(Ut - Un) + (πt-1 - πe,t-1)
where Ut is the actual unemployment rate, Un is the natural rate of
unemployment, and β is the sensitivity of inflation to the output gap.
In this case, we have β = 2 and Un = 5%.
Starting from πt-1 = 0.12, we can plug in values for Ut based on the
central bank's policy of maintaining the unemployment rate 1
percentage point above the natural rate until inflation reaches 2%.
The results are:
πt = 0.12 - 2(0.07 - 0.05) + (0.12 - 0.12) = 0.1 πt+1 = 0.1 - 2(0.06 -
0.05) + (0.1 - 0.1) = 0.08 πt+2 = 0.08 - 2(0.05 - 0.05) + (0.08 - 0.08) =
0.06 πt+3 = 0.06 - 2(0.04 - 0.05) + (0.06 - 0.06) = 0.04
Therefore, it will take three years for inflation to reach 2%.
c. We can stop maintaining the unemployment rate above the natural
rate once inflation has reached 2%. This occurs in year t+3, so the
central bank needs to keep the unemployment rate elevated for
three years.
d. Credibility refers to the belief that the central bank will follow
through on its stated policies. If the central bank is credible in its
commitment to reducing inflation, then people will adjust their
expectations accordingly and the central bank may be able to achieve
its goal with a smaller sacrifice ratio. In this case, suppose that
people now believe that the central bank is committed to reducing
inflation to 2%, so they set their expectations accordingly:
πe,t = 0.02
We can then solve the Phillips curve equation for inflation:
πt = πe,t + β(Ut - Un)
Using the same approach as before, we can calculate inflation for
each year:
πt = 0.02 + 2(0.07 - 0.05) = 0.12