1. Assume that the United States economy is in long-run equilibrium with an expected inflation rate of 6 percent and an unemployment rate of 5 percent. The nominal interest rate is 8 percent. (a) Using a correctly labeled graph with both the short-run and long-run Phillips curves and the relevant numbers from above, show the current long-run equilibrium as point A. (b) Calculate the real interest rate in the long-run equilibrium. (c) Assume now that the Federal Reserve decides to target an inflation rate of 3 percent. What open-market operation should the Federal Reserve undertake? (d) Using a correctly labeled graph of the money market, show how the Federal Reserve’s action you identified in part (c) will affect the nominal interest rate. (e) How will the interest rate change you identified in part (d) affect aggregate demand in the short run? Explain. (f) Assume that the Federal Reserve action is successful. What will happen to each of the following as the economy approaches a new long-run equilibrium? (i) The short-run Phillips curve. Explain.
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