Questions:

1.Consider the following IS/LM model for a closed economy:

? = ?(? − ?) + ?(?) + (? − ?)

(M / P)d = L(i,Y)

Assume that the real interest rate (?) is given by ?=?−?e, where ?e represents expected inflation, and ? denotes the nominal interest rate. Answer the following:

(i) What happens to output and interest rate in this model, when a fall in the price level is expected in the future?

(ii) Suppose that the economy is in recession and the government tries to bring down the deficit by reducing its expenditures. Using this model, explain what kind of monetary policy the Central Bank should pursue to complement government’s fiscal policy to steer the economy out of recession.

2. Consider a two-period model of a closed economy with government. Assume that the representative agent is endowed with ?1 and ?2 as initial endowments in period 1 and period 2 respectively and has the utility function ? = ln ?1 +? ln ?2, where ?1 and ?2 denote consumption and ? is the discount rate. Suppose that the government spends ?1 and ?2 in period 1 and period 2 and finances its expenditure through lump-sum taxes ?1 and ?2 in periods 1 and 2 respectively.

(i) Derive the inter-temporal budget constraints of the representative agent and the government.

(ii) Suppose if government borrows ? units at the interest rate of ? to finance its expenditure in period 1, derive the amount of taxes that would satisfy its inter-temporal budget constraint. Explain whether Ricardian Equivalence holds in this situation.

3. Suppose the economy has the Phillips curve ?? = ??−1 − 0.5(?? − ???), where the natural rate of unemployment is given by the average of past two years’ unemployment: ??? = 0.5 (??−1 + ??−2).

(i) Why might the natural rate of unemployment depend on recent unemployment (as is assumed in the preceding equation)?

(ii) Suppose the Central bank follows a policy to reduce the inflation rate permanently by 1 per centage point. What effect will that policy have on the unemployment over time?

(iii) What is the sacrifice ratio for this economy in practice?

4. Consider that the central bank is attempting to minimize the following loss function subject the inflation-unemployment trade off as given below:

Minimize ? = (?1 − ??)2 + ?(?1 − ??)2       (Loss function)

subject to ?1 = ?0 + ?(?1 − ??)       (Phillips curve).

(i) Explain what is meant by the Central bank’s loss function and how are the central bank’s preferences reflected in the loss function? Draw the loss ‘circles’ for the cases where ? = 1; ? > 1; ? < 1. In which of the three cases will the central bank reduce inflation back to target quickest after an inflation shock?