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Question 1: Consider the DAD—DAS framework: IS Curve: Y, = l7 — an + 6?
Aggregate Supply (AS): 7r, 2 xi + €50”; — 17') + cf
Taylor Rule: 2'; = 7r; + ¢fi(7rt — 1r*) + ¢y(Y¢ — 17)
Fisher Equation: 2', = n + 7rf+1
Variable / Parameter Description Output at time t
Natural level of output
Real interest rate Demand shock m Rate of inflation at time t
7r: Expected inflation for time t “to Supply shock m Nominal interest rate Inflation target (constant over time) Monetary policy parameter, positive 95,, Monetary policy parameter, positive The variables are described in the table above. The shock terms 6? and cf, are stochastic and uncorrelated, with expected value of zero. The parameter oz > 0 is a
positive constant. (a) Assume that expectations are adaptive, e.g. 7r: = 7&4, and assume that 7r* = 0.
Find the equilibrium values for the level of output and inflation in this economy at
time t. Assuming no shocks in equilibrium, explain the effects on the equilibrium of
a decrease in qbfl. (Answer Space: max 2 pages)

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