Suppose the economy is at its natural rate of unemployment of 6% with a real output of $900 billion, but policymakers plan to reduce inflation from 8 percent to 4 percent gradually over a period of six years by creating a recession.

1. If the sacrifice ratio is 3, relative to maintaining full employment, what is the cumulative loss in output this recession will entail? a) $30b or less                 b) more than $30b but less than $60b   c) more than $60b but less than $90b           d) more than $90b (the answer is 108, d)

2. If Okun's law says that an extra percentage point of unemployment above the natural rate corresponds to a drop in output of 2 percentage points, what unemployment rate will the economy be required to experience over these six years?

a) 6% or less                    b) more than 6% but not more than 7% c) more than 7% but not more than 8%                d) more than 8%

 

1)  d) more than $90b (the answer is 108, d)

2) b) more than 6% but not more than 7%

Step-by-step explanation

1) Sacrifice ratio measures the cost of reducing inflation by a percentage point in terms of GDP.

Sacrifice ratio = Cumulative cost as a percentage of GDP/ Percentage point reduction in the inflation rate.

The policymakers of this economy want to reduce inflation from 8 percent to 4 percent gradually over 6 years and as the sacrifice ratio is 3 therefore by putting these value in the formula of sacrifice ratio we can get the cumulative loss in output

3 = Cumulative cost as a percentage of GDP/4%

12% = Cumulative cost as a percentage of GDP

As real output or GDP is $900 billion therefore

Cumulative cost as percentage of GDP = 12% × $900 billion = $108 billion.

Cumulative cost as a percentage of GDP = $108 billion.

2) Okun's law is a measure that is used to measure how the unemployment rate different from the natural rate of unemployment changes the output gap of the economy. If Okun law says that one extra percentage point of unemployment greater than the natural rate of unemployment results in a drop of output by 2 percentage point and as we know from the calculation in part "A" that the Cumulative cost as a percentage of GDP is 12% over the 6 years, therefore, every year economy is required to reduce its output by 2% and as the natural rate of unemployment is 6% so the unemployment the economy is required to experience over 6 years is more than 6% but not more than 7%(at most one extra percentage point of unemployment greater than the natural rate of unemployment over the 6 years so that output fall by 2 percentage points every year).