3. Dynamic Model with Phillips Curve The economy behaves according to the follow

Question

3. Dynamic Model with Phillips Curve The economy behaves according to the following three equations: Okun's Law: ut = ut-1-0.7gyt + 2.8% Phillips curve: .-R-1-0.7u, + 14% Aggregate Demand: gytgmt Say for time 0, 1, ...., t-1 the economy is in the medium run equilibrium. The Fed is holding money supply growth at 2%. a) What are the natural output growth rate and unemployment rate? b) What is the medium run equilibrium rate for inflation? Is the price level going up, going down or stable in this medium run equilibrium? c) Now money growth is increased from 2% to 4% at time t. Compute the unemployment and inflation rates for time t and t +1. d) The new money growth rate will eventually lead to a new medium run equilibrium. Is the price level going up, going down or stable in the new medium run equilibrium?

Explanation / Answer

According to Okuns Law,

Ut-U(t-1) = -b(Gyt-Gy) comparing this equation with above given equation we get  -b(Gyt-Gy) = -0.7(Gyt-4%)

As Gyt growth rate of output & Gy is natural Growth rate of Output which is 4% in this case.

Similarly Natural unemployment rate is using Phillps Equation given in data we get

-0.7%(Ut-2%) where Ut is actual unemployment rate for a time period t and Un is natural unemplyment rate that is 2% in this case.

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