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Economics 135 Problem Set 4 Key Due at the beginning of class on Tuesday, July 26 (25 points possible) Department of Economics UC Davis 1. Professor...
SRAS curve 4A. (1 point) Derive a general mathematical expression for the solution to the output gap in any period t: B. (1 point) Suppose that the Federal Reserve increases the nominal interest rate by 0.5 percentage points for every 1 percentage-point increase in the inflation rate. What is the value of ? Briefly explain. C. (2 points) Assume the following parameter values in Period 0, along with the value of you computed in Part B above: = 0,̅ = 0, = 1, ̅ = 0.022!"#"$, = 0.5, = 0.033!"#"$, ̅ = 1. Prior to the shock, the economy is at potential output and inflation is equal to the inflation target. Starting from potential output ( = 0, assume that there an oil price shock that only lasts for one period, Period 1 (̅ = 0.02). In all periods after Period 1, the value of ̅ = 0 and there are no spending shocks in any period ( = 0). Calculate numerically and show on an AD/SRAS diagram the initial eqilibrium, the shock in Period 1, and two periods following the shock. That is, calculate , &, 'as well as ,&, ' and graphically illustrate using an AD/SRAS diagram. D. (2 points) What is the Taylor Principle and why does it lead to instability? Intuitively explain.
