Question

The medium-run equilibrium is characterized by four conditions:

- Output is equal to potential output (Y=Y_n)

- The unemployment rate is equal to the natural unemployment rate (u=u_n)

- The real policy interest rate is equal to the "natural" rate of interest (the one that makes aggregate demand equal to potential output).

- The expected rate of inflation is equal to the actual rate of inflation.

(a) Assume that the level of expected inflation is formed in such a way that this year's expected inflation is equal to last year's inflation: πe=πt−1πe=πt−1. What is the behavior of the rate of inflation in a medium-run equilibrium?

Select one:

a. it will not change, meaning that the price level remains constant year after year.

b. it will be constant and equal to an exogenous constant, that does not depend on past inflation.

c. it will be increasing or decreasing depending on the value of the natural interest rate.

d. it will not change: the value of inflation is simply equal to its value in the previous period.

(b) Now assume, instead, that the level of expected inflation is equal to an exogenous constant:

πe=π¯πe=π¯

What is the behavior of actual inflation in the medium-run equilibrium?

Select one:

a. it is increasing or decreasing, depending on the value of the "natural" rate of interest

b. It is constant, and equal to its previous period.

c. It is stable and equal to the exogenous constant π¯π¯

d. inflation is increasing at a rate equal to π¯

(c) Imagine that the economy is in a medium-run equilibrium. Assume that expected inflation is equal to past inflation (πe=πt−1πe=πt−1).

In this situation, the Government decides to increase public spending (G), while leaving taxes unchanged. How will macroeconomic variables react to this fiscal expansion?

Select one:

a. output will increase; the unemployment rate and nominal wages will remain the same (equal to the values determined by the WS-PS model); the inflation rate will start increasing year after year.

b. output will decrease; the unemployment rate and nominal wages will remain the same (equal to the values determined by the WS-PS model); the inflation rate will start decreasing year after year.

c. output will increase; the unemployment rate will decrease; nominal wages will remain the same; the inflation rate will start increasing year after year.

d. output will increase; the unemployment rate will decrease; the growth rate of nominal wages and the inflation rate will start increasing year after year.

(d) How must the Central Bank react to the increase in G, in order to ensure that the economy sticks to the medium-run equilibrium?

Select one:

a. it must increase the interest rate.

b. it must decrease the interest rate.

c. it must ensure that the interest rate remains unchanged.

d. it must do nothing: output is already equal to potential output.

e. it must increase taxes.

Answer 1

A).

Here actual inflation is equal to expected inflation and the expected inflation is equal to the previous period inflation. So, here the actual inflation is constant and will not change, => the correct answer is “D”.

B).

Now, let’s assume that the “actual inflation” and “expected inflation” both equal to an exogenous constant implied the “actual inflation” and “previous period inflation” is equal to the exogenous value, => it will not change and will be same, => the correct answer is “B”.

C).

As the “G” increases that will increase the “AD” given the “AS”. So, the equilibrium output “Y” increases, unemployment rate decrease, the nominal wage and price level both increases.

So, the correct answer is “D”.

D).

The increase in “G” increase the “Y” that will increase the money demand. So, there will be an excess demand in the money market, => the central bank will increase “intersect rate” to clear the money market. So, the correct option is “A”.