Assume that inflation depends on two things: the level of aggregate demand, indicated by the inverse of unemployment (1/U), and the expected rate of i
Assume that inflation depends on two things: the level of aggregate demand, indicated by the inverse of unemployment (1/U), and the expected rate of inflation (π et). Assume that the rate of inflation (πt) is given by the equation:
\r\nπt = (48/U – 6) + πet
\r\nAssume initially (year 0) that the actual and expected rate of inflation is zero.
\r\n(a) What is the current (natural) rate of unemployment
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(b) Now assume in year 1 that the government wishes to reduce unemployment to 4 per cent and continues to expand aggregate demand by as much as is necessary to achieve this. Fill in the rows for years 0 to 4 in the following table. It is assumed for simplicity that the expected rate of inflation in a given year (πet) is equal to the actual rate of inflation in the previous year (πt–1).
\r\n(c) Now assume in year 5 that the government, worried about rising inflation, reduces aggregate demand sufficiently to reduce inflation by 3 per cent in that year. What must the rate of unemployment be raised to in that year?
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(d) Assuming that unemployment stays at this high level, continue the table for years 5 to 7.
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