The effects of a permanent decrease in the rate of nominal money growth Suppose that the economy can be described by the following three equations:

ut − ut−1 = −0.4(gyt − 3%) Okun’s law

πt − πt−1 = −(ut − 5%) Phillips curve gyt = gmt − πt Aggregate demand

a. Reduce the three equations to two by substituting gyt from the aggregate demand equation into Okun’s law.

Assume initially that ut = ut−1 = 5%, gmt = 13% and πt = 10%.

Now suppose that money growth is permanently reduced from 13% to 3%, starting in year t.

b. Compute (using a calculator or a spreadsheet program)

unemployment and inflation in year t, t + 1, . . . , t + 10.

c. Does inflation decline smoothly from 10% to 3%? Why or why not?

d. Compute the values of the unemployment rate and the inflation rate in the medium run.

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