TUTORIAL 8 (Money growth, Inflation and Output)

(Answers are provided as a guide but not limited to the following)

Question 1

First, write the equation that represents the Okun's law relationship. Second, what does
Okun's law represents.

Suggested answer:

The following equation represents the Okun's law relation: ut - ut-1 = -(gyt - g y). Okun's law
summarizes the relationship between changes in the unemployment rate and output growth.
Specifically, for the unemployment rate to decrease, output growth must rise, hence a negative
relationship. Given the Okun’s Law equation, output growth rate would have to rise
above some natural output growth rate in order to reduce unemployment rate.

Question 2

What are the two factors why the rate of output growth is at least equal to the normal
growth rate of output to prevent the unemployment rate from rising? Explain.

Suggested answer:

The rate of growth of output in an economy depends on two key factors, namely, employment
growth rate and technological advancement over time.

To maintain a constant unemployment rate, either employment growth must equal the
summation of labor force growth plus the labour productivity growth.
Assuming natural output growth rate (potential GDP) is equal to 3% and assuming the
employment growth is 1.7%. This means output growth is less than natural output growth rate
(Y < Yn), hence U > Un. In this case, the short run output growth is only driven mainly by
labour force growth rate at 1.7% growth but no labour prouctivity growth.

However, over time or in long run, with technological advancement, productivity will grow, ie
assuming productivity (output per worker) grow by 1.3%, causing output growth to rise by a
total of 3% (ie 1.7% + 1.3%). When the actual output growth rate is 3%, then the unemployment
rate is maintained ie no changes as output growth rate = natural output growth rate. = 3%.

As such, the output growth of an economy is very dependent on both employment growth
(which is made up of both labour force growth and labour productivity growth) and
technological advancement.

Question 3

Output growth that is 1% above normal output growth rate (potential GDP) causes only
a 0.4% reduction in the unemployment rate rather than a 1% reduction in the
unemployment rate. What are the two reasons why unemployment does not fall by the
same 1%? Explain.

Suggested answer:

Firstly, when demand increases, firms do not need to increase employment by the same
percentage as the increase in output because of labor hoarding.

Secondly, when employment increases, we observe an increase in labor force participation that
would offset some of the increased employment effects on the unemployment rate.
Question 4

Suppose nominal money growth equals 3% and inflation equals 5%. Given this
information, explain what happens to the growth rate of output.

Suggested answer:

The aggregate demand relation relates output growth to the difference between nominal
money growth and inflation.

gyt  gmt  t => 3% - 5% = - 2%

Output growth is -2%. This occurs because the real money supply is decreasing (as nominal
money growth of 3% is < inflation rate of 5%), therefore, aggregate demand is falling, hence
a negative output growth rate.
Question 5

Explain the relationship among the following variables in the medium run when central
bank decides to adopt contractionary monetary policy (decrease in nominal money
supply):

(1) unemployment and output growth;

(2) normal growth rate of output;
(3) nominal money growth;
(4) adjusted nominal money growth; and
(5) inflation.

Suggested answer:

In the medium run, unemployment is constant and unemployment = natural rate of

unemployment. This implies that output growth = normal growth rate of output.

Nominal money growth is whatever has been set by the central bank. In this case, since central
bank adopt a contractionary monetary policy, the nominal money growth decreases.

The adjusted money growth is simply the difference between nominal money growth and the
normal growth rate of output.

From above equation, inflation will equal the rate of adjusted money growth.