In this exercise, we analyze how loose monetary policy can lead to high rates of inflation. Imagine that at t=1, policymakers observed that GDP was lower than what they expected. So, they assumed that output was below its potential due to a negative aggregate demand shock. Use the IS-MP + Phillips Curve model to predict what happens to short-run output (Ỹ₂) and inflation (™) in each of the following cases: Case A: Assume that there is a negative aggregate demand shock (ā < 0) but the Central Bank does not respond so the interest rate is r = r. Case B: Assume that there is a negative aggregate demand shock (ā < 0) and the Central Bank responds by lowering the interest rate: rt < F. Case C: Assume that policymakers misinterpreted the data and what actually happened is that GDP was low because potential output was low, while there was no aggregate demand shock. That is: there is no aggregate demand shock (ā = 0) but still the Central Bank responds by lowering the interest rate: rt < ñ.

In this exercise, we analyze how loose monetary policy can lead to high rates of inflation. Imagine that at t=1, policymakers observed that GDP was lower than what they expected. So, they assumed that output was below its potential due to a negative aggregate demand shock. Use the IS-MP + Phillips Curve model to predict what happens to short-run output (Ỹ₂) and inflation (™) in each of the following cases: Case A: Assume that there is a negative aggregate demand shock (ā < 0) but the Central Bank does not respond so the interest rate is r = r. Case B: Assume that there is a negative aggregate demand shock (ā < 0) and the Central Bank responds by lowering the interest rate: rt < F. Case C: Assume that policymakers misinterpreted the data and what actually happened is that GDP was low because potential output was low, while there was no aggregate demand shock. That is: there is no aggregate demand shock (ā = 0) but still the Central Bank responds by lowering the interest rate: rt < ñ.

ENGR.ECONOMIC ANALYSIS

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ISBN:9780190931919

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Publisher:NEWNAN

Chapter1: Making Economics Decisions

Section: Chapter Questions

Problem 1QTC

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Question

Exercise 2. The Great Inflation of the 70s²
In this exercise, we analyze how loose monetary policy can lead to high rates of inflation.
Imagine that at t=1, policymakers observed that GDP was lower than what they expected. So, they
assumed that output was below its potential due to a negative aggregate demand shock. Use the
IS-MP + Phillips Curve model to predict what happens to short-run output (Ỹ) and inflation (π)
in each of the following cases:
Case A: Assume that there is a negative aggregate demand shock (ā < 0) but the Central Bank
does not respond so the interest rate is r₁ = ñ.
Case B: Assume that there is a negative aggregate demand shock (ā < 0) and the Central Bank
responds by lowering the interest rate: r < F.
Case C: Assume that policymakers misinterpreted the data and what actually happened is that
GDP was low because potential output was low, while there was no aggregate demand shock. That
is: there is no aggregate demand shock (ā = 0) but still the Central Bank responds by lowering the
interest rate: rt < ñ.

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