Reference no: EM133952369
Assignment:
Dynamic AS-AD Model
Consider a dynamic AS-AD model. The dynamic aggregate supply curve is given by
πt = πt-1 +0.5(??t-100)+??t
And the dynamic aggregate demand curve is given by
??t=100-0.5(πt-2),
where ??t denotes output level and πt denotes inflation rate in percentage terms. ??t captures a supply shock.
(a) Calculate the long-run equilibrium values for output and inflation.
Suppose the economy is in the long-run equilibrium you computed in part (a). Suppose that at time ??=0 there is an adverse supply shock ??0=5 that lasts for two periods before reverting to zero. That is, ??0=??1=5 and ??t=0 for all subsequent ??≥2.
(b) Compute the values of output and inflation in period ??=0 upon impact. What does this imply for the nominal and real interest rates in period ??=0? Explain how the actual inflation rate you find compares to the inflation rate that would have prevailed if there was no monetary policy reaction to inflation.
(c) Compute the values of output and inflation in period ??=1. Explain how expected inflation in period ??=1 compares to expected inflation in period ??=0. What role does expected inflation play in determining output and inflation in period ??=1?
(d) Explain qualitatively the subsequent time paths of output and inflation after the adverse supply shock ends (for ??≥2). Does inflation return to its long run equilibrium value in period t = 2? Why or why not?