unsweruepends on the marginal propensity to consume ulitase,OI Slay cohstant). A
ID: 1114520 • Letter: U
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unsweruepends on the marginal propensity to consume ulitase,OI Slay cohstant). Also, explain how your 3. (Chapter 9, Question 3 modified) The two paths to the medium-run equilibrium explored in the chapter make two different assumptions about the formation of the level of expected inflation. One path assumes the level of expected inflation equals lagged inflation, and the level of expected inflation changes over time (i.e adaptive expectations). The other path assumes the level of expected inflation is anchored to a specific value and never changes. Suppose that an economy begins in the medium-run equilibrium where actual and expected inflation equals 2 percent in period a) Illustrate the economy on an IS-LM-PC diagram by indicating the medium-run equilibrium as point A and labeling the potential output evel as YN, the initial expected inflation rate a and the initial neutral real interest rate as r Assume that )t-3/ i. Suppose there is a decrease in consumer ce b) 27 2 change the real policy rate, how do output, unemployment rate, inflation rate, and expected inflation rate in period t +1 compare to the equilibrium in period r? On the diagram from part (a), indicate the equilibrium in period t 1 as point B. If the central bank leaves the real policy rate unchanged, how do output, unemployment, actual inflation, and expected inflation in period t +2 compare to the equilibrium in period t +1? On the diagram from part (a), indicate the equilibrium in period t + 2 as point C ii. p. I of 2Explanation / Answer
Answer. This is related to the expectations. There are two types of expectations, Adaptive expectations and Rational expectations.
Adaptive expectations: In this, agents assumes that the future value will depend upon the [Theta] times the previous year value.
Rational Expectations: In this, agents assumed that the future value not only depends upon the previous year's value but depends on other factors also.
(A) Now, in period t,, inflation is 2%. If there is a rise in consumer confidence, then spending will increase. It will shift IS curve to the right and AD curve will also shift to right. As aggregate demand rises, prices also rises with it. Hence, inflation in period t+1 rises.
(B) If expected inflation in t+2 = inflation in t+!, then it remains same. If the policy changes, only then it will change.
(C) This is the case of adaptive expectations, in which they are expecting the future inflation rate to rise by 'k', were k is constant.
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