Suppose that natural real GDP is constant. For every 1 percent increase in the rate of inflation above its expected level, firms are willing to increase real GDP by 2 percent. The output ratio is initially 100 and the inflation rate equals 2 percent.

a) Based upon the preceding information, draw the short-run Phillips Curve.

b) What is the growth rate of nominal GDP in the economy?An adverse supply shock raises the inflation rate associated with every output ratio by 3 percentage points.

c) Draw the new short-run Phillips Curve.

d) The government chooses to follow a neutral policy in response to this shock. What will be the growth rate of nominal GDP? What will be the new rate of inflation? What will be the output ratio?

e) If the government chose to follow an accommodating policy, what would be the new inflation rate? The output ratio? The growth rate of nominal GDP?

f) If the government chose to follow an extinguishing policy, what would be the new inflation rate? The output ratio? The growth rate of nominal GDP?

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