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Problem Set #5

Student’s Name
Institutional Affiliation
Instructor
Course
Date
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Problem Set #5

I.

a. What is the natural rate of unemployment?

π_t = π_t_e + 0.1 - 2u_t

π_t_e = θπ_t-1
π_t = θπ_t-1 + 0.1 - 2u_t
At the natural rate of unemployment (u_n), the actual rate of unemployment (u_t) equals the

natural rate (u_n), and the expected rate of inflation (π_t_e) equals the actual rate of inflation

(π_t).

π_n = θπ_n-1 + 0.1 - 2u_n

π_n = 0.1 - 2u_n

To find (u_n), we set the inflation rate (π_n) to zero

0 = 0.1 - 2u_n

2u_n = 0.1

u_n = 0.05

0.05*100

Natural rate of unemployment is 5%

b. Determine the rate of inflation in years 𝑡, 𝑡 + 1, 𝑡 + 2, and 𝑡 + 5.

Phillips curve equation: 𝜋_𝑡 = 𝜋_𝑡_𝑒 + 0.1 - 2𝑢_𝑡

Since the authorities decide to bring the unemployment rate down to 4% (u_t+1 = u_t+2 = u_t+5
= 0.04) and hold it there forever,

𝜋_𝑡 = 𝜋_𝑡_𝑒 + 0.1 - 2(0.04)

𝜋_𝑡 = 𝜋_𝑡_𝑒 + 0.1 - 0.08

𝜋_𝑡 = 𝜋_𝑡_𝑒 + 0.02

The rate of inflation in years 𝑡, 𝑡 + 1, 𝑡 + 2, and 𝑡 + 5 = expected rate of inflation in those

respective years, plus 0.02.

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The rate of inflation = 2%

c. Do you believe the answer given in (b)? Why or why not?

I do not believe in the answer given in b. This is because, the assumption that the rate of

inflation remains constant at 2% for years 𝑡, 𝑡 + 1, 𝑡 + 2, and 𝑡 + 5 is based on the assumption

that individuals form their expectations solely based on past inflation rates, without considering

other factors. In reality, individuals do not solely rely on past inflation rates to form their

expectations. They also consider other factors such as current economic conditions and policy

changes.

d. Why might 𝜃 increase in this way?

𝜃 might increase from 0 to 1 in year 𝑡 + 5 due to a change in the government policy or

Changing economic conditions. The government may introduce new policies aimed at reducing

inflation and promoting price stability. By increasing 𝜃, the government aims to indicate its

commitment to controlling inflation and maintaining stability in the long term.

On the other hand, if the economy experiences a period of high inflation, policymakers

may increase 𝜃 to adjust inflation expectations and curb inflationary tendencies. The government

may choose to adopt a more aggressive stance in fighting inflation by adopting a stronger

commitment to price stability through an increase in 𝜃.

e. What will the inflation rate be in years 𝑡 + 5, 𝑡 + 6, and 𝑡 + 7?

𝜃 value of 1,

𝜋𝑡+5 = 𝜃𝜋𝑡+4 + 0.1 - 2(0.04)

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𝜋𝑡+5 = 1(𝜋𝑡+4) + 0.1 - 0.08

𝜋𝑡+5 = 𝜋𝑡+4 + 0.02

𝜋𝑡+4 = 0.02, 𝜋𝑡+5 = 0.02 + 0.02 = 0.04

Inflation rate in year 𝑡 + 5 =4 %

For year 𝑡 + 6

𝜋𝑡+6 = 𝜃𝜋𝑡+5 + 0.1 - 2(0.04)

𝜋𝑡+6 = 1(𝜋𝑡+5) + 0.1 - 0.08

𝜋𝑡+6 = 𝜋𝑡+5 + 0.02

𝜋𝑡+5 = 0.04, 𝜋𝑡+6 = 0.04 + 0.02 = 0.06

Inflation rate in year 𝑡 + 6=6%

Year 𝑡 + 7

𝜋𝑡+7 = 𝜃𝜋𝑡+6 + 0.1 - 2(0.04)

𝜋𝑡+7 = 1(𝜋𝑡+6) + 0.1 - 0.08

𝜋𝑡+7 = 𝜋𝑡+6 + 0.02

𝜋𝑡+6 = 0.06, 𝜋𝑡+7 = 0.06 + 0.02 = 0.08

Inflation rate in year 𝑡 + 7=8%

f. Do you believe the answer given in (e)? Why or why not?

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I do not believe the answer given in e. This is because the answer assumes that people

continue to adapt their expectations based on past inflation, even after 𝜃 increases to 1. In reality,

people may also consider other factors such as economic condition

II.

a. Suppose 𝑚 = 0.03 and 𝑧 = 0.04. What is the natural rate of unemployment if 𝛼 = 1? if 𝛼 =

2? What is the relation between 𝛼 and the natural rate of unemployment? Interpret your

answer.

𝑢𝑛 = (𝑚 + 𝑧)/𝛼

𝑚 = 0.03

𝑧 = 0.04.

The natural rate of unemployment for 𝛼 = 1 and 𝛼 = 2;

𝛼=1

𝑢𝑛 = (𝑚 + 𝑧)/𝛼

= (0.03 + 0.04)/1

= 0.07

𝛼 = 2: 𝑢𝑛

= (𝑚 + 𝑧)/𝛼

= (0.03 + 0.04)/2

= 0.035

The natural rate of unemployment is 7% when 𝛼 = 1 and 3.5% when 𝛼 = 2.

The relation between 𝛼 and the natural rate of unemployment is inverse. As 𝛼 increases,

the natural rate of unemployment decreases. This means that when wage flexibility is higher

(larger 𝛼), the response of wages to changes in the unemployment rate is greater, leading to a
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lower natural rate of unemployment. On the other hand, when wage flexibility is lower (smaller

𝛼), the response of wages to changes in the unemployment rate is smaller, resulting in a higher

natural rate of unemployment.

A higher value of 𝛼 (greater wage flexibility) implies that wages are more responsive to

changes in the unemployment rate. This can be beneficial in adjusting the labor market

efficiently, as wages can adjust quickly, leading to a lower natural rate of unemployment. On the

other hand, a lower value of 𝛼 (lower wage flexibility) indicates that wages are less responsive to

changes in the unemployment rate, which may result in a higher natural rate of unemployment

and potentially hinder adjustments in the labor market.

b. Suppose that as a result of an oil price increase, 𝑚 increases to 0.06. What is the new

natural rate of unemployment if 𝛼 = 1? if 𝛼 = 2? Would an increase in wage flexibility tend

to weaken the adverse effect of an oil price increase?

𝑢𝑛 = (𝑚 + 𝑧)/𝛼, where 𝑚 is the change in oil prices and 𝑧 is a constant

𝛼=1

𝑢𝑛 = (𝑚 + 𝑧)/𝛼

(0.06 + 0.04)/1

= 0.1

𝛼=2

𝑢𝑛 = (𝑚 + 𝑧)/𝛼

(0.06 + 0.04)/2
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= 0.05

The new natural rate of unemployment if a=1 is 10% and 5% when 𝛼 = 2

An increase in wage flexibility (larger 𝛼) tends to weaken the adverse effect of an oil

price increase. When 𝛼 is higher, it means that wages are more responsive to changes in the

unemployment rate. As a result, when 𝑚 increases due to an oil price increase, wages can adjust

more quickly, which can help offset the negative impact on employment and reduce the natural

rate of unemployment. Therefore, an increase in wage flexibility can mitigate the adverse effects

of an oil price increase on the labor market.

III. Label each of the following statements true, false, or uncertain. Explain your choice

carefully.

a. The present discounted value of a stream of returns can be calculated in real or nominal

terms.

True: The present discounted value takes into account the effects of inflation and adjusts

the future returns to their equivalent value in today's purchasing power. In nominal terms, the

present discounted value does not consider inflation and discounts the future returns at the

nominal interest rate.

b. The higher the one-year interest rate, the lower the present discounted value of a

payment next year.

True: The present discounted value of a payment next year is inversely related to the one-

year interest rate. As the interest rate increases, the discount factor used to calculate the present

discounted value decreases, resulting in a lower present value for the payment next year.
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c. Interest rates are normally expected to be constant over time.

False: Interest rates are not normally expected to be constant over time. Interest rates can

fluctuate in response to changes in economic conditions, monetary policy decisions and other

factors.

d. Bonds are a claim only to a sequence of constant payments over a number of years.

False: Bonds are not limited to a sequence of constant payments over a number of years.

Bonds can have various structures, including fixed-rate bonds with constant coupon payments.

The specific terms and conditions of a bond determine the pattern and variability of its payments.

e. The yield curve normally slopes up.

Uncertain: The slope of the yield curve can vary depending on economic conditions and

market expectations. In a normal economic environment, the yield curve tends to slope upward.

IV. You want to save $2,000 today for retirement in 40 years. You have to choose between

the two plans listed in (i) and (ii).

(i) Pay no taxes today, put the money in an interest-yielding account, and pay taxes equal to

20% of the total amount withdrawn at retirement. (In the U.S., such an account is known

as a regular individual retirement account, or IRA.)

(ii) Pay taxes equivalent to 15% of the investment amount today, put the remainder in an

interest-yielding account, and pay no taxes when you withdraw your funds at retirement.

(In the U.S., this is known as a Roth IRA.)

a. What is the expected present discounted value of each of these plans if the interest rate is

1%? 10%?
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Present Value = FV / (1 + r)n

FV = Future Value

r = Rate of return

n = Number of periods

Plan (i) - Regular Individual Retirement Account (IRA)

a. Interest rate = 1% The future value is $2,000.

Present Value = $2,000 / (1 + 0.01)^40 = $1,214.41

b. Interest rate = 10% The future value is still $2,000. Using the formula: Present Value = $2,000

/ (1 + 0.1)^40 = $148.64

Plan (ii) - Roth IRA

a. Interest rate = 1%

The initial investment is $2,000, and after paying taxes (15%), I am left with $1,700.

Present Value = $1,700 / (1 + 0.01)^40 = $1,027.47

b. Interest rate = 10%

The initial investment is $2,000, and after paying taxes (15%), I am left with $1,700.:

Present Value = $1,700 / (1 + 0.1)^40 = $49.37

b. Which plan would you choose in each case? Explain your logic clearly.

At 1% interest rate

Plan (i) has a present value of $1,214.41.

Plan (ii) has a present value of $1,027.47.

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In this case I would prefer Plan (ii) because it has a higher present value, meaning I would have

more money available at retirement.

At 10% interest rate

Plan (i) has a present value of $148.64.

Plan (ii) has a present value of $49.37.

In this case, I would prefer Plan (i) because it has a higher present value, meaning I would have

more money available at retirement.