PART II (15 MARKS)

(1)
The economy has the Phillips curve:
π = π-1 – 0.5(u – 0.05)
Here π= Inflation
U= unemployment
The natural rate of unemployment is the rate at which the inflation rate does not
deviate from the expected inflation rate.
So Here, the expected inflation rate is just last period’s actual inflation rate.
We will set the inflation rate to the same level as the previous period inflation rate,
that is,
π = π–1,
we find that u = 0.05.
Thus, the natural rate of unemployment is 5%

(2)
In the short run, which is a single period, the expected inflation rate is fixed at the level of
inflation in the previous period, π–1.
Hence, the short-run relationship between inflation and unemployment is just the
graph of the Phillips curve which is slope of –0.5,
and it passes through the point where π = π–1 and u = 0.05.
As shown in graph below in the long run, expected inflation equals actual inflation,
so that π = π–1,
and output and unemployment equal their natural rates.
The long-run Phillips curve thus is vertical at an unemployment rate of 5%

(3)
To reduce inflation, the Phillips curve tells us that unemployment must be above its
natural rate of 5 percent.

Phillips’s curve is π – π–1 = –0.5(u – 0.05)

Since we want inflation to fall by 4% points, which means π – π–1 = –0.04.
equating this into the left side of the above equation,
–0.04 = –0.5(u – 0.05).
u: u = 0.13.
Hence, we need 8 percentage points of cyclical unemployment above the natural rate
of 5 percent.
Okun’s law says that a change of 1 percentage point in unemployment translates into
a change of 2 percentage points in GDP.
Hence, an increase in unemployment of 8 percentage points corresponds to a fall in
output of 16 percentage points.
The sacrifice ratio is the percentage of a year’s GDP that must be forgone to reduce
inflation by 1 percentage point.
Dividing the 16- percentage-point decrease in GDP by the 4-percentage-point
decrease in inflation,
we find that the sacrifice ratio is 16/4 = 4

SECTION 2

PART III (35 MARKS)

(III). Ques.1 part A (10 MARKS)

(A).
In this economy equation Y= C+ I + G
Where Y (National income GDP) = 8000
G (Government purchases) = 2500
T (Tax)= 2000
C (Consumption)= 1000 + 2/3 (Y-T)
So, private saving, public saving, national saving will be,
Private saving =
S = Y (GDP) – C (consumption) – T (tax)
S = 8000-2000- (1000+ 2/3 8000 -2000)
S = 1000
Private saving is equal to 1000
Public savings=
S = T (tax) – G (government purchases)
S = 2,000 –2,500
S = -500
Public saving is equal to -500
National savings is sum of private and public saving,
which will be 1000 + (-500)
National saving is equal to 500

(B) The equilibrium interest rate= r is the value that clears the market of funds that are
loanable.
S= Ir which is 500= 1200-100r
r= 7
which means equilibrium interest rate is 7%
(C) . If G is cut to 2000 the results are as following:
 Private saving
S= Y-T-C
8000-2000- (1000+ 2/3 8000-2000)
Private savings is equal to 1000
Public savings
S= T-G
2000-2000
Public savings is equal to 0
National savings will be sum of public and private savings which is,
National saving= 1000- 0
National saving is equal to 0
(D) Equilibrium interest rate will be
S= Ir
1000= 1200-100r
Value of r = 2%
So, after reducing G by 500 equilibrium interest rates will be 2%

Ques.1 part C (10 MARKS)

Money supply is the sum of currency and deposit (M = C+ D) and it can also be calculated by
M= B*m where m is the money multiplier and B is the monetary base.
(a) Money supply is $1000 since currency is 1000 and deposit = 0
M= C+ D
So, M=1000 + 0
M= $1000
(b) Money supply is $1000, currency is 0 and DD (Demand deposits) is equal to 1000
with bank keeping 100% as reserves, here we will calculate by using M= B*m
Where B (monetary base) = 1000
m (money multiplier) = ((1+cr)/(cr+rr)),
((1+0)/ (0+1) = 1
m=1
hence, M= B*m
M= 1000*1
M=1000
(c) Here, currency ratio (cr) = 0
Reserve ratio (rr)= 0.20
M= (1+cr)/(cr+rr) * B
M= (1+0 / 0+2) * 1000
M= $5000
(d) Currency demand (cr) = 1
Reserve ratio (rr) = 0.20
 M= (1+cr)/(cr+rr) * B
M= (1 + 1)/ (1 + .2) * 1000
M= 1.67* 1000
M= $1670
(e) For increasing money supply 10%, there will be increase in monetary base by
10%, because increase in monetary base is directly proportional to increase in
money supply
So, bank should increase its monetary base by $100