II. Problems - You have to show your work. No credit without an explanation (30 marks each).

Suppose the Phillips curve is given by:

U = 10+0.1(p e p ) where U is the unemployment rate in %, p e,p are expected inflation and actual inflation, respectively.

(a) If the unemployment rate drops by 1 percentage point, how much does inflation change by? (6 marks)

(b) If p e = 5%, what are the equilibrium inflation and unemployment rate? (6 marks)

(c) What is the marginal rate of substitution (MRS) between inflation and unemployment of the

country's authorities in equilibrium? (6 marks)

(d) Explain in words what that MRS means. (6 marks)

(e) Are this country's authorities "hard nosed" or "wet" in their preferences relative to authorities with MRS = 4 preferences? (6 marks)