Question

2. Consider an economy in a long-run equilibrium with Y = 40 and 1=3. A demand shock in period one causes output to rise to 45 and inflation rises to 4. Then, the updating of expected inflation to equal 4 causes output in period two to decline to 43.85, and inflation to rise to 4.77. Assuming no further shocks, calculate the values of output and inflation for period three.

Answer 1

Here we noted that inflation moving from period 1 to period 2, then the expected inflation is 1. which decline the outut by,

$=45-43.85=1.15$

The another change in inflation is,

$4.77-4=0.77$,

So the resulting change in output would be,

$1.15\times 0.77=0.89$

So, the output in period 3 is,

$43.85-0.89=42.96$

The further move in inflation would,

$0.89\times \frac{0.77}{1.15}=0.596$

So the inflation in period 3 is,

$=5.36$