Explain why expansionary monetary policy affects output

Question

Money and Banking

1. In the 2001 recession unemployment rose to 6%, which is above the natural rate of unemployment of 5%. Suppose a Phillips curve equation: π_t = (0.5)(u* - u_t-1) + π_t^e . If expected inflation is 2% then what will wage inflation be?

2. Again consider an unemployment rate of 6%, and a natural rate of 5%.

a.) By what percentage was output below potential GDP?
b.) If potential GDP is $2.25 trillion by how much would we need to raise GDP to in order to see full employment at 5% again?

3. Suppose that output is $2.31, the natural rate is 4.5%, potential GDP is $2.25, inflation was 3% last year, expectations are adaptive, and the phillips curve equation is π = π^e + 0.5 {(Y -Y*) / Y*}. What will the inflation rate be this year?

4. Consider the following version of the Phillips curve: π_t = π_t^e - 1.25 (u-u*) + ν. Suppose that the expectations are 2% and the natural rate is 5.5%. Then the economy is hit by an oil price shock and a financial crisis. The oil price shock embodied an inflation rise of 2 percentage points and inflation turned out to be 1.5%. What effect did the financial crisis have on the unemployment rate?

5. Explain why expansionary monetary policy affects output before it affects inflation.

6. If there is a negative expenditure shock, what will be the effect of countercyclical monetary policy on output and inflation. When will these effects occur if there are time lags. What is the fed's goal in using countercyclical policy?

7. Suppose the target rate of inflation is 1%, the current rate of inflation rate is 2.5%, and the output gap is -1%.

a) What is the interest rate if the Taylor rule is: r = 1.5 +1.75 + 1.25(π - π^T)?
b) Using the equation in part (a), describe the meaning of the number 1.75.
c) Using the equation in part (a), describe the meaning of the number 1.25.
d) What is the interest rate if the Taylor rule is: r = 1.5 +1.25 + 1.25(π - π^T)?
e) Comment on these two Taylor rules. Which leads to higher interest rates, which leads to higher output? Which leads to higher inflation? Which represents a more hawkish Fed? Which represents a more dovish Fed?
f) The Taylor rule describes which interest rate?

Excel Problem: For this problem, you must calculate your answer using excel. You must ALSO display the equations neatly in excel and upload the spreadsheet.

8. Suppose that the economy responds to the real interest rate according to the following equation: Y_t = Y* - Y* (1.5) (r_t-1 - 0.035). The phillips curve is: π = π^e + 0.5 {(Y -Y*) / Y*} + v.

Potential GDP is $2.25 billion; expectations are adaptive; the 2018 inflation rate was 5%. A price shock sufficient to raise inflation by two percentage points hits the economy in 2019. In an effort to bring inflation down they had set interest rates at 5% in 2018. How should the federal reserve react if they desire to bring inflation down to 3%. When will they achieve that goal? (Hint: maintain plenty of decimal places.)