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Question

Use the dynamic AD-AS model we have discussed in class to solve for inflation

as a function of only lagged inflation and supply and demand shocks. Assume

target inflation is constant.

1. According to the equation you have derived, does inflation return to its

target after a shock? Explain. Hint: Look at the coefficient on lagged inflation.

(5 points)

2. Suppose the central bank does not respond to changes in output but only

to changes in inflation, so that θ y = 0. How, if at all, would this fact

change your answer to part (a)? (5 points)

3. Suppose the central bank does not respond to changes in inflation but

only to changes in output, so that θ π = 0. How, if at all, would this fact

change your answer to part (a)? (5 points)

4. Suppose the central bank does not follow the Taylor principle but in-

stead raises the nominal interest rate only 0.8 percentage point for each

percentage-point increase in inflation. In this case, what is θ π ? How does

a shock to demand or supply influence the path of inflation? (5 points)

Step-by-step answer

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Subject: Business, Economics

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