Question

Suppose the US economy is in recession. The unemployment rate is 7% and the Federal Reserve Bank is considering using monetary policy to expand output. Assume the bank knows, with certainty, that:

i.             absent changes in monetary policy, unemployment will still be 7% next year;

ii.           the natural rate of unemployment is 5%;

iii.          from Okun's law, 1% more output growth for a year leads to a 0.4% reduction in the unemployment rate.

Also assume the bank can effectively use monetary policy to increase output growth rates as desired, i.e., the interest rate is sufficiently far away from the zero lower bound. However, the bank is uncertain about the effect that changes in its policy rate, the Official Cash Rate (OCR), have on output growth. To inform its decisions, the monetary policy committee summons the research department to produce predictions of the one-year response of US output growth to a decrease of 1% in the OCR. The research department, using three different macroeconometric models, presents the results from three different models:

Model (a): output growth is predicted to increase by 1.0% (moderate monetary transmission channel)

Model (b): output growth is predicted to increase by 0.6% (weak monetary transmission channel)

Model (c): output growth is predicted to increase by 2.0% (strong monetary transmission channel)

The research department further informs that each model prediction is equally likely, and that effects for OCR changes different than -1% are proportional to these predictions, e.g.: a decrease of 2% in the OCR is predicted to increase output growth by 2% according to model (a), 1.2% according to model (b), and 4% according to model (c), and so on.

Using the scenario information above answer the following questions.

Note: for the numerical questions, please provide a numerical answer in percentage points, e.g., 1 for 1%, -2 for -2%, etc.

What is the output growth rate needed to lower the unemployment rate to the natural rate of unemployment?

Answer 1

Okun's Law statement defines that 2% increase in output correspondes to a 1% decline in the rate of cyclical unemployement.A 0.5% increase in labor force participation a 0.5% increase in hours worked per employee and a 1% increase in output per hours worked. That is a 1% increase in output will lead to 0.5% decrease in unemployment. So here we have the natural unemployment rate is 5% but it can be seen increased into 7% we can reduce the increased unemployment rate by increasing the output that is by increasing the productivity. The GDP doesnt always depend on employment but also on other factors such as utilization of resources and number of hours worked etc. To decrease the rete of unemployment we have to increase the gdp that is our current unemployment rate is 7% to reduce 1% of decrease  unemployment rate we have to increase our output into 2% so we have to increase our output by 4% to get our unemployment rate into natural rate that is 5%. So when we increase our output by 4% there will be a decline in unemployment rate by 2%, this is according to our Okun's law .