1. Suppose Okun's Law holds and a one percentage point increase in the unemployment rate reduces real output by 2% of full-employment output. The expectations-augmented Phillips curve is given by

pi = pi(e) - 2 (u - 0.05)

Suppose pi = 0.06 and pi(e) = 0.02

(a) What is the natural rate of unemployment?

(b) What is the actual rate of unemployment?

(c) How much is actual GDP compared to full-employment GDP?

2. The relationship between inflation and unemployment is given by

pi = pi(e) - 3(u- 0.06)

(a) Graph the short-run and long-run Phillips curves.

(b) What is the value of the natural rate of unemployment?

(c) If actual inflation is 0.02 abd expected inflation is 0.05, what is the unemployment rate?

(d) If actual inflation is 0.08 and expected inflation is 0.05 what is the unemployment rate?

3. Starting on a Phillips curve with expected inflation equal 5% and umemployment at its natural rate, show what happens to unemployment if the Central Bank tries to reduce inflation, but has no credibility. As time passes and people realize that the inflation rate is now lower, what happens to the short-run Phillips curve?

4. Suppose the reserve-deposit ratio is

res = 0.5 -2 i

where i is the nominal interest rate. The currency-deposit ratio is 0.2 and the monetary base equals 100. The real quantity of money demanded is given by the money demand function

L(Y, i) = 0.5Y -10 i

where Y is real output. Currently the real interest rate is 5% and the economy expects an inflation rate of 5%. Assume the price level P is equal to 1.

(a) Calculate the money multiplier.

(b) Calculate the reserve-deposit ratio.

(c) Calculate the money supply.

(d) Calculate the value of output Y that clears the asset market.

5. The money supply is $12 million, currency held by the public is $2 million, and the reserve-deposit ratio is 0.2.

(a) What is the quantity of bank deposits?

(b) What is the quantity of bank reserves?

(c) What is the quantity of the monetary base?

(d) What is the money multiplier ( give a number)?

6. Describe, in general terms, the strategy of monetary policy, explaining how monetary-policy tools are used to achieve the goals of monetary policy. What intermediate stages are important in going from tools to goals? What are the links between the different stages? How does the Bank of Canada use this stategy today?

1. (a) 0.05; (b) 0.03; (c) 4% higher.

2. (a) Long run: Vertical line at u = u(natural rate)=0.06. Short run: downward sloping line (curve) crossing the long-run curve at u = u(natural rate).
(b) 0.06; (c) 0.07; (d) 0.05.

3. The unemployment rate rises as the economy moves along the Phillips curve and as inflation declines. As time passes, inflation expectations begin to decline, shifting the Phillips curve down and to the left until the unemployment rate returns to its natural rate and inflation and expected inflation are equal at a lower level.

4. (a) 2.4; (b) 0.3; (c) 240; (d) 482.

5.(a) 10 million; (b) 2 million; (c) 4 million; (d) 3.

6. The Bank uses its tools to influence intermediate targets that in turn affect the goal variables. The link between the tools and intermediate targets is an economic relationship such as the money multiplier, which relates changes in the money supply. The link between intermediate targets and the goal variables is an economic model. Today the Bank targets the bank rate fairly directly, but watches many indicators to figure out the correct funds rate.