Problem Set #2 ANSWERS
Due Tuesday, October 2, 2007
Problem Sets MUST be word-processed except for graphs and equations.
QUESTIONS
1. In 1998, the U.S. economy was in equilibrium at potential GDP with an inflation rate of 4%. In 1999, there was
a substantial increase in investment in anticipation of Y2K. In 2000, the Federal Reserve engaged in a
contractionary monetary policy of exactly the size necessary to completely offset the increased investment in
1999. Also in 2000, autonomous investment fell, reversing all of its 1999 increase.
a. Based only on this information, use a DAD – SAS model diagram to clearly show the effects of these
events on equilibrium output and the inflation rate and during 1999, 2000, and 2001. Also be sure to clearly
identify where the economy and inflation settle when the adjustment process is complete.
π Yn
π2 SAS2
SAS3
π3
SAS0 = SAS1
π0, π1
π(final)
DAD2 DAD0,2a DAD1
Y2 Y3 Y0 Y1 Y
Problem Set #2 ANSWERS (Fall 2007) 1/10
, b. Provide a brief economic explanation for what happened to economic output and inflation because of the
events described above. Also be sure to discuss where economic output and inflation finally settle at the
end of the adjustment process.
Year 1 (1999): The increase in autonomous investment shifts the DAD curve from DAD0 to DAD1,
raising the output from Y0 to Y1. Inflation holds steady at π0 because inflation responds with a lag to
changes in Y and u.
Year 2 (2000): 3 things happen. First, because Y1 > Y0, inflation rises endogenously from π0 to π2,
shifting the SAS curve from SAS0 to SAS2. Second, Fed tightening shifts the DAD curve back from
DAD1 to DAD2a = DAD0. Third, the decline in autonomous investment shifts the DAD curve from
DAD2a to DAD2. Higher inflation raises interest rates, reduces interest-sensitive spending, and
decreases output to Y2 < Y0.
Year 3 (2001): Because Y2 < Y0, inflation falls endogenously from π2 to π3, shifting the SAS curve
down from SAS2 to SAS3. Lower inflation reduces interest rates, increases interest-sensitive
spending, and increases output to Y3 < Y0.
The adjustment process continues until inflation has fallen sufficiently to raise economic activity
back to its natural level at Y0. This will be at the intersection of DAD2 and the horizontal natural
output line at Y0.
Problem Set #2 ANSWERS (Fall 2007) 2/10
Due Tuesday, October 2, 2007
Problem Sets MUST be word-processed except for graphs and equations.
QUESTIONS
1. In 1998, the U.S. economy was in equilibrium at potential GDP with an inflation rate of 4%. In 1999, there was
a substantial increase in investment in anticipation of Y2K. In 2000, the Federal Reserve engaged in a
contractionary monetary policy of exactly the size necessary to completely offset the increased investment in
1999. Also in 2000, autonomous investment fell, reversing all of its 1999 increase.
a. Based only on this information, use a DAD – SAS model diagram to clearly show the effects of these
events on equilibrium output and the inflation rate and during 1999, 2000, and 2001. Also be sure to clearly
identify where the economy and inflation settle when the adjustment process is complete.
π Yn
π2 SAS2
SAS3
π3
SAS0 = SAS1
π0, π1
π(final)
DAD2 DAD0,2a DAD1
Y2 Y3 Y0 Y1 Y
Problem Set #2 ANSWERS (Fall 2007) 1/10
, b. Provide a brief economic explanation for what happened to economic output and inflation because of the
events described above. Also be sure to discuss where economic output and inflation finally settle at the
end of the adjustment process.
Year 1 (1999): The increase in autonomous investment shifts the DAD curve from DAD0 to DAD1,
raising the output from Y0 to Y1. Inflation holds steady at π0 because inflation responds with a lag to
changes in Y and u.
Year 2 (2000): 3 things happen. First, because Y1 > Y0, inflation rises endogenously from π0 to π2,
shifting the SAS curve from SAS0 to SAS2. Second, Fed tightening shifts the DAD curve back from
DAD1 to DAD2a = DAD0. Third, the decline in autonomous investment shifts the DAD curve from
DAD2a to DAD2. Higher inflation raises interest rates, reduces interest-sensitive spending, and
decreases output to Y2 < Y0.
Year 3 (2001): Because Y2 < Y0, inflation falls endogenously from π2 to π3, shifting the SAS curve
down from SAS2 to SAS3. Lower inflation reduces interest rates, increases interest-sensitive
spending, and increases output to Y3 < Y0.
The adjustment process continues until inflation has fallen sufficiently to raise economic activity
back to its natural level at Y0. This will be at the intersection of DAD2 and the horizontal natural
output line at Y0.
Problem Set #2 ANSWERS (Fall 2007) 2/10
