1. In the late 1960s, Milton Friedman and Edmund Phelps argued that there was not astructural relationship between inflation and unemployment rates. In particular, the tradeoff could only exist in the short -run.a) (10 points) The tradeoff between unemployment and inflation was muchdiscussed throughout the 1960s as there appeared to be a clear tradeoffbetween unemployment and inflation. In fact, we traced out the Phillips curvebeginning in the early 1960s and continuing through the end of the decade. Inthe space below, recreate the Phillips curve that we constructed in the lectures,being sure to label diagram completely. At minimum, you should haveunemployment / inflation combinations for 1961, 1962, 1964, 1966, and 1969.Connect the dots and we have the tradeoff between unemployment and inflationduring the 1960s, aka, the Phillips curve.b) (10 points) Now explain why the Phillips curve that you constructed can only be ashort-run phenomenon at best. In particular, explain exactly why, as we wentthrough the decade of the 1960s, we continuously move up and to the northwestalong the Phillips curve…. from relatively high rates of unemployment and lowinflation to relatively low rates of unemployment and high rates of inflation. Inyour answer, make sure discuss the short run aspect of this curve and why, inthe long-run, the Phillips curve is vertical (hint: expected inflation, unexpectedinflation, actual real wages, and expected real wages should be a big part of yourexplanation).2. In this question, we are going dig deeper into the Taylor Rule and it variants(modifications). You will need the following links to answer the following questions.Note, each link takes you to a page where right above the graph on left, there is a"download data in graph" tab – click on it and that will give you access to the data youneed.NAIRUGDP GrowthPGEInflation PCE coreUnemployment RateInflation PCEEffective Federal Funds RateAs Taylor assumed, we assume the equilibrium real rate of interest, r* = 2% and theoptimal inflation rate, the target inflation rate is also equal to 2%.1a) (10 points) Using the ‘standard’ Taylor rule with Inflation PCE (not the core), andusing end of 2011 data (2011-10-01) what is the federal funds rate implied by the’standard’ Taylor Rule? According to the actual federal funds rate (use theEffective Federal Funds Rate), is the Fed being hawkish or dovish? Explain.b) (10 points) Repeat part a) using the modified version of the Taylor using theunemployment gap instead of the GDP gap just like we did in the lectures. Also,use the PCE core rate of inflation instead of overall inflation like you used above the Fed arguably cares more about core inflation than overall inflation. Accordingto the actual federal funds rate (use the Effective Federal Funds Rate), is the Fedbeing hawkish or dovish? Which "Taylor" rule explains Fed behavior better, theoriginal or the modified Taylor Rule? Explain.c) (10 points) Let’s go back in time to the fourth quarter of 1965 (1965-10-01) whenthe "We are all Keynesians" was featured in Time magazine. We argued that this washeyday of Keynesian economics so we would expect to get dovish results. Using theoriginal Taylor Rule that you used in part a) and the modified Taylor Rule that you used inpart b), prove that the Fed was dovish according to both versions of the Taylor Rule.d) (10 points) We now go back to the Volcker period where he was known as beinga hawk on inflation. Using the data from the second quarter of 1982 (1982-04-01),prove that the Volcker Fed was hawkish according to both versions of the Taylor RuleTrue/ False (40 points total – 2 points each)1) According to the "We are all Keynesians Now" article, the labor secretary at that timewanted the unemployment rate to fall down to 3%.2) The misery index in 1980 exceeded 25.3) The mid to late 1970s was the ‘heyday’ of Keynesian economics in the US economy.4) Keynes believed that it was the responsibility of the government to use its powers toincrease production, incomes and jobs.5) Consistent with his thought on spending heavily, Keynes was known as an excellenttipper.6) The steeper the SRAS curve, the steeper the short-run Phillips curve.7) If the long-run aggregate supply curve is vertical so is the long-run Phillips curve.8) Friedman and Phelps agreed that there is a trade-off between unemployment andinflation, but only in the long run.9) If actual inflation is lower than expected inflation, then the actual real wage is higher thanthe expected real wage. This being the case, firms will lay off workers.210) According to the Taylor Rule described in the lectures, if the Fed is getting an A+, thenthe federal funds rate should be set at 5%11) According to the Taylor principle, if actual inflation rises by 1% over target inflation, thenthe Fed should raise the federal funds rate by 2% to make sure that the real federalfunds rate rises which is referred to as "leaning against the wind.12) If the actual federal funds rate is higher than the funds rates implied by the Taylor rule,then we say that the central bank is hawkish.13) If actual inflation rises one percent above target and the central bank raises the actualfunds rate by one percent then according to the Taylor rule, the central bank is beinghawkish.14) According to the Taylor rule, the Greenspan Fed was hawkish during the new economyyears.15) According to the Taylor rule, the Greenspan Fed was hawkish during the job-lessrecovery as well as the job-loss recovery.16) One way to explain the apparent tradeoff between inflation and unemployment duringthe 1960s, expected inflation was consistently higher than the actual inflation implyingthat firms would be willing to higher more workers given this difference betweenexpected and actual inflation. The result therefore would be higher inflation and lowerunemployment, consistent with the facts during the 1960s.17) We argued that the modified version of the Taylor rule during the jobless recoveryfollowing the 1990 – 1991 recession explained Greenspan and the Fed’s behavior muchbetter than the original Taylor Rule.18) According to the Phillips curve analysis, if expected inflation is equal to actual inflationthen we are at NAIRU. However, if actual inflation is higher than expected, then theactual unemployment rate will be higher than that associated with NAIRU.19) If firms and workers had perfect foresight as to inflation so that actual = expectedinflation at all times, then the Phillips curve would be vertical and thus, there would be notrade between unemployment and inflation, even in the short run.20) We argued that a federal funds rate target of 4% is consistent with the stance ofmonetary policy being neutral as in neither tight nor loose.*************************************************************ECON104HOMEWORK#12(100pointstotal)1) (20 points) Explain, in five sentences or less, exactly why the trade deficit in the USincreased from 1995 to 2000. There are two specific reasons. Make sure you explainclearly (the intuition) why each reason would add to our trade deficit.2) (40 points total)a. (10 points) Suppose that you received your college degree from Penn State andnailed a great job over in Europe in the summer of 2001. Given that your familyremains in the US, you make sure that you visit the family every November bytraveling from Europe to the US. We are going to compare the cost of thisvacation, in terms of euros, during two different periods: November 2002 andNovember 2012. We assume that the cost of the trip, in terms of $ US, remainsthe same at $1,000 in both periods. Using the link below and rounding down totwo decimals, compare the euro cost of the trip in November 2002 vs. the eurocost of the trip in November 2012.See the St. Louis Federal Reserve site for $ per euro exchange rate (to getactual data click on "view data" on left hand side of page)b.(30 points – 15 points for explanation and 15 points for correct and completelylabeled diagram) Using the same link above, we are now going to use oursupply/demand framework for US $ to model the movement in the euro
per $exchange rate between December 2007 (the very beginning of the GreatRecession) and November 2008 (pretty much the height of the global financialcrisis).Note that the data is in $ per euro so you need to convert it into euro per dollarbefore proceeding. For example, $ 1.2 per euro is converted by 1/1.2 = .833meaning that $1 = .83 euro (this is the vertical axis on your graph, i.e., euro per$).Rounding down again to two decimals, draw a supply and demand diagram likewe did numerous times in the lectures labeling the vertical axis as euro per $ andthe initial supply and demand curves labeled with 12/07, Label this initial point aspoint A.Now explain what happened to each curve and WHY between 12/07 and 11/08.Label this new point (11/08) as point B with your supply and demand curveslabeled accordingly(Hint: the two obvious facts during this period is that the 1) US was in a deeprecession and 2) we were at the height of the (global) financial crisis (in 11/08).Assume all else is constant.True/ False (40 points total – 2 points each)1) In a closed economy, savings = investment is the same as the closed economy goodsmarket equilibrium condition we know as Y = C + I + G.2) If income exceeds absorption, then the economy is ‘consuming beyond its means.’3) In the open economy goods market equilibrium with two large countries, the sum of theabsorptions must equal the sum of the incomes produced by the two countries.4) Goods market equilibrium in an open economy requires that savings equals investmentplus the current account.5) If savings exceeds investment then the country is running a trade deficit where NX < 0.6) If NX is positive then the country is consuming beyond their means and must borrowfrom the rest of the world.7) During the mid 2000s, the current account deficit in the US exceeded 10% of GDP.8) We argued that when the economic growth in the US is greater than the (economic)growth rates of our trading partners, the trade deficit in the US should get larger, all elseconstant.9) A country that intervenes in the foreign exchange market to keep their currency weak isconsistent with the country being export oriented.10) We argued that when the US economy grew briskly during the new economy, the supplyof US dollars in exchange for other currencies rose since along with economic growth,our appetite for imports grows as well. This effect, all else constant, would weaken thevalue of the $.11) We argued that the E. Asian and Russian crises would map to our foreign exchangemarket analysis as a decrease in the supply of dollars resulting in a stronger US dollar.12) During the Reagan Administration, the current account became a major economic issue.In particular, the US began running a large current account surplus where US exportswere much larger than US imports.13) Export oriented countries prefer a weaker currency relative to a stronger currency.14) If there is pressure for the Chinese yuan to appreciate against the US dollar, then Chinacan ‘fight’ this appreciation by buying $ with their yuan.15) We argued that one reason that interest rates are low on government securities is due toChina’s exchange rate regime.16) Monetary policy is thought to be stronger in an open economy relative to a closedeconomy since if the Fed, for example, wanted to prevent the economy fromoverheating, they would raise interest rates. Along with the normal closed economyimpact on consumption and investment, we also would have a stronger dollar whichwould lower net exports, adding to the power of monetary policy.17) One reason fiscal policy is thought to be stronger in an open economy relative to aclosed economy is due to the fact that in an open economy setting, the change in theinterest rate effects the exchange rate and thus, adds power to fiscal policy through thisexchange rate channel.18) A rush to the safe haven of $ US during a financial crisis is depicted in the supply /demand model in the $ US market as an increase in the demand to exchange foreigncurrencies in for $. The end result should be $ US appreciation, all else constant.19) We argued that the $ US was appreciating in the early years of the ReaganAdministration due to the expansionary fiscal policy during this time.20) When people refer to the twin deficits in the US they are most likely referring to the neweconomy years since this was the time twin deficits occurred in the US economy.
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