1. In April 2009, the U.S. unemployment rate was 8.9%
a. According to one version of Okun's law, the GDP gap is twice the difference between the actual unemployment rate and the natural rate of unemployment. If the natural rate of unemployment was 5.4% in April 2009, calculate the GDP gap
b. In April 2009, the inflation rate was about 0%. According to the Taylor rule, what were the recommended nominal and real federal funds rates?
c. The nominal interest rate cannot fall below zero. What might the Fed do to try to achieve the optimal real interest rate you calculate in Part b?
2. As the textbook notes, countries with more independent central banks tend to have lower average inflation rates. Nevertheless, the average unemployment rates among countries is unrelated to the degree of central bank independence. How would one explain this finding using the Phillips curve?
3. Suppose a president facing budget deficits asked his economic advisers to solve the following dilemma: he would like to reassure the "financial markets" that he is serious about proposing a long run plan that will eventually reduce the federal budget deficit further, but he is concerned that any contractionary fiscal policy might push the economy into a recession. One adviser suggests that the president propose (and Congress pass) legislation now that will raise taxes, starting four years from now. Assume throughout this problem that everyone believes that taxes will indeed rise four years from now.
a. Why would the simple Keynesian consumption function predict that this strategy would work?
b. Many of the president's economists argue that the legislation will affect the economy now even if taxes do not increase for another four years. Explain their reasoning and the theory (or theories) they use.
c. A small group of economists argues that the tax increase will have no effect on real GDP, regardless of when it takes effect. Why?
d. Even if the theory cited by economists in Part c is correct, other economists argue that the tax increase will still affect consumption when it takes effect if people have borrowing constraints. Explain their reasoning.
4. Some economists have proposed the rule that the cyclically adjusted budget deficit always be balanced. Compare this proposal to a strict balanced-budget rule. Which is preferable? What problems do you see with the rule requiring a balanced cyclically adjusted budget?