Answer Happy

Question 4 Assume an economy characterised by the following 3 equations: IS curve: Yt = 10 -0.7(rt-1) Monetary policy rule: rt - r = m(It-) Phillips curve: TT = 1-1 + 5y + z where y, is the output gap, r, is the real interest rate, n, is the inflation rate, T = 2% is the inflation target of the Central bank. F is the real interest rate when the output gap is zero. m is a constant parameter. z represents an inflation shock. Page 4 of 6 a) Assume that m = 1.5. Derive the AS and AD curves and represent them on a diagram. Represent the point at which the economy is in its long-run equilibrium. Clearly label the diagram. b) What happens to the AD curve when m increases to m = 3? Represent the new AD curve on the previous diagram and explain why the shape of the AD curve changes. Assume that there is a positive shock to productivity which lowers the cost of producing goods in the economy. Everything else remains constant. As a result, at time t=0, z <0. At time t=1, 2, 3, ..., Z= 0. c) What happens to output and inflation at time t=0? Represent your answer on an ASIAD diagram and explain how the adjustment in inflation and output takes place. d) What happens to output and inflation at time t=1? What happens at time t=2,3, ...? Represent your answer on an AS/AD diagram and explain how the adjustment in inflation and output takes place. (15 marks)