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Suppose the economy is in long-run equilibrium in 2019. In 2020, an adverse expenditure shock reduces output by 2 percent.
a. Assume the central bank uses TR-I in given Table. Using the equations for the AE and Phillips curves in the online appendix, derive the paths of output, inflation, and the interest rate from 2020 until the economy is back in long-run equilibrium.
b. Redo the calculations in part (a) assuming TR-II. Which of the two rules is better for stabilizing output? For stabilizing inflation? Explain.
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