HOMEWORK ASSIGNMENT 6
Answer Key
Problem (1), Mankiw chapter 12, page 341. [54 pts: 3 pts for each box.]
| Floating exchange rates |
Aggregate income |
Exchange rate |
Trade balance |
| a. A fall in consumer confidence about the future induces consumers to spend less and save more. |
no change |
decrease |
increase |
| b. The introduction of a stylish line of Toyotas makes some consumers prefer foreign cars over domestic cars. |
no change |
decrease |
no change |
| c. The introduction of automatic teller machines reduces the demand for money. |
increase |
decrease |
increase |
| | | |
| Fixed exchange rates | | | |
| a. A fall in consumer confidence about the future induces consumers to spend less and save more. |
decrease |
no change |
no change |
| b. The introduction of a stylish line of Toyotas makes some consumers prefer foreign cars over domestic cars. |
decrease |
no change |
decrease |
| c. The introduction of automatic teller machines reduces the demand for money. |
no change |
no change |
no change |
Problem (3), Mankiw chapter 13, page 378. [44 pts: 11 pts each part] It is useful to rearrange the equation given in the problem as
DELTA PI = -0.5 (U-0.06),
where DELTA PI is the change in PI, or PI - PI-1.
- At the natural rate of unemployment, DELTA PI = 0. Substituting and solving yields U = 0.06 or six percent.
- The short-run and long-run relationships are quite different.
- The graph of the short-run relationship is a downward-sloping line that passes through the current inflation rate (ten percent) and the natural rate of unemployment. The line has slope = -0.5. The vertical intercept (found by substituting U=0) is at 13 percent inflation.
- The graph of the long-run relationship is a vertical line at unemployment = 6 percent.
- To reduce inflation by 5 percentage points, set DELTA PI=-0.05 and solve to get U = 0.16 or sixteen percent. This amounts to 0.10 or ten percent cyclical unemployment (that is, unemployment above the natural rate).
Multiplying 10% cyclical unemployment by 2 (according to Okun's law) yields a sacrifice of 20 percent of GDP.
The sacrifice ratio is 20 percent loss of GDP divided by 5 percentage points reduction in inflation, or four.
- Inflation can be reduced rapidly with brief high level of unemployment, or it can reduced slowly with a prolonged moderate level of unemployment. Here are two scenarios. It is easy to find others.
- As shown in part (c), inflation can be reduced in "cold-turkey" fashion by raising the unemployment rate to sixteen percent for one year.
- Alternatively, the inflation rate can be reduced one percentage point at a time over five years. Substituting DELTA PI = 0.01 in the above equation shows that each year the unemployment rate would have to remain at eight percent.
[end of answer key]