Aggregate Supply and Stabilization Policies

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Question #1: Chapters 13 and 14 (Aggregate Supply and Stabilization Policies)
Suppose that an economy can be described as follows (Total 30 marks):
u = ut-ut-1 = - 0.5(%Yt- 4) (Okun's Law)
t = te-0.5(ut-un) +t (Phillip's Curve)
te = t-1 (Adaptive Expectations)
Yt= 350rt-7000+2(Mt/Pt) (LM equation)
Yt=7000-350rt (IS equation)

(i) What is adaptive expectation? Describe the benefits and limitations of assuming that economic agents form adaptive expectations when the authorities try to forecast the effects of economic policies (2 marks).
Ans: Adaptive expectation means that people for their expectations of what would happen in the future based on what have happened in the past. People do not revise their outlook even when new information is discovered. The benefit of making this assumption is that the modeling would be simple, but cost is that it is not very realistic.

Adaptive expectations means that people form their expectations about what will happen in the future based on what has happened in the past. For example, if inflation has been higher than expected in the past, people would revise expectations for the future.
since its assumption of rationality is more consistent with wider economic theory.

(ii) (Hint: Do not cancel out the Y's.) Use the IS and LM equations to find the Aggregate Demand (AD) equation and show that the AD equation can be expressed as
%Yt= %Mt-t (3 marks)

Ans: Use the IS equation to solve for r, then sub this r into the LM equation to get Yt=Mt/Pt, which can be rewritten in percentage change form as %Y= %M-. This equation is also called the quantity theory of money, with velocity a constant. Derived in lecture notes.

From IS curve: Yt=7000-350rt, we can write:
350rt=7000 - Yt
or rt=7000/350 - Yt/350
rt=20 - Yt/350
substitute into the LM curve: Yt= 350rt-7000+2(Mt/Pt)
Then Yt= 350*(20 - Yt/350)-7000+2(Mt/Pt)
or Yt= 7000 - Yt -7000+2(Mt/Pt)
2Yt= 2(Mt/Pt)
Yt= Mt/Pt
Then we take the logrithm on both sides:
ln Yt= ln (Mt/Pt)
ln Yt= ln ...