Suppose that the economy can be described by the following three equations: u t

Question

Suppose that the economy can be described by the following three equations:

ut - ut-1 = -0.4*(gyt - 3%) Okun's law

t - t-1 = -(ut - 5%) Phillips curve

gyt = gmt - t Aggregate Demand

where ut is the unemployment rate in year t and gyt the growth rate of output from yeat t-1 to year t, t is the inflation rate in year t and gmt is the growth rate of money supply from year t to year t-1.

a) What is the natural rate of unemployment for this economy?

b) Suppose the unemployment rate is equal to the natural rate and that the inflation rate is 8%. What is the growth rate of output? What is the growth rate of money supply?

Explanation / Answer

Answer a)

Setting t equal to t-1t^e, as per the the Phillips curve relation,

Unemployment = 5%

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