ESSAY. Write your answer on a separate sheet of paper.

1) Consider an economy in long-run equilibrium with an inflation rate (π) of 0.08 per year and a natural unemployment rate of 0.05. Suppose Okun's law holds and a one percentage point increase in the unemployment rate reduces real output by 2% of full-employment output. The expectations-augmented Phillips curve is given by
π=πe -2.5(u-0.05). Consider a two-year disinflation. In the first year, π = 0.06 and π e = 0.08. In the second year, π = 0.04 and
πe =0.05.

(a) In the first year, what is the value of the unemployment rate? (b) Inthefirstyear,bywhatpercentagedoesoutputfallshortoffull-employmentoutput?

(c) In the second year, what is the value of the unemployment rate?

(d) In the second year, by what percentage does output fall short of full-employment output?

(e) What is the sacrifice ratio for this disinflation?

2) For this question, use the Keynesian IS-LM model with flexible exchange rates. Eastland's main trading partner is Westland. Suppose Westland undertakes an expansionary monetary policy.

(a) What is the effect of Westland's expansionary monetary policy on Eastland's real exchange rate in the short run, assuming no change in Eastland's policies?

(b) WhatistheeffectofWestland'sexpansionarymonetarypolicyonEastland'srealexchangerateinthe long run, assuming no change in Eastland's policies?

(c) What is the effect of Westland's expansionary monetary policy on Eastland's nominal exchange rate in the short run and in the long run?