The firms and workers in Bayernland form expectations adaptively. The firms and

Question

The firms and workers in Bayernland form expectations adaptively. The firms and workers in Realland form expectations rationally. Their otherwise identical economies are initially in equilibrium at the natural level of output with 6 percent inflation. The central banks of both Bayernland and Realland make credible commitments to reduce the growth rate of money until they achieve 2 percent inflation.c) Using Okun’s Law and making the assumption that the sacrifice ratio in Realland is 4.5, what is the ”cost” of bringing down inflation in Bayernland in terms of GDP and unemployment? Provide two answers, one for the case where the drop in inflation is achieved over one year, and the other where the process is allowed to take five years. Which case strikes you as more realistic?

Explanation / Answer

Answer:

According to Okun's Law 1% increase in the cyclical employment is inversely related to 2% of growth in real GDP. The sacrifice ratio of Realland is 4.5. Sacrifice ratio is giving up 1% of GDP to reduce inflation by 2%. Both the economies are identical and are at equilibrium at natural level of output with 6 percent inflation. The firm and workers of Bayernland form adpative expectation. So the expectated inflation of general public in Bayernland will be their past inflation.

The cost of bringng the inflation down in terms of GDP:

Given, the sacrifice ratio = 4.5

GDP Loss = (Inflation Reduction) * (Sacrifice Ratio)

The central bank plans to reduce the inflation from 6% to 2%. Hence,

GDP Loss = 2 * 4.5 = 9

So the loss in GDP will be 9%

The Cost of Reducing Inflation in terms of Unemployment

Following Okun's Law 1% increase in inflation reduces 2% of decrease in unemployment and vice versa.

So if central bank commit to reduce the inflation from 6% to 2%, this will increase the unemployment by 8%.

Hence the loss in case of employment due to reduction in inflation will be 8%.

Case 1: Drop in Inflation for 1 year

If the drop is inflation is for year the impact on the loss which is 9% incase of GDP and 8% in employment will be huge. There will be drastic change in growth and people will loose their job. Hence this will bring economy in an unstable position.

Case 2: Drop in Inflation over 5 years

If the drop in inflation is for 5 years, the effect of the loss (GDP and employment) will spread over entire time period. Hence will not effect geberal public dramtically. Also the central bank target will be acheived.

The case 2 (dropping inflation over 5 years) strikes more realistic.

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