2. In a certain economy, the expectations-augmented Phillips curve is p = pe - 4(u - un) and un = 0.05.

a. Graph the Phillips curve of this economy for an expected inflation rate of 0.075. If the Fed chooses to keep the actual inflation rate at 0.075, what will be the unemployment rate?

b. An aggregate demand shock (resulting from the loss of consumers’ confidence) decreases the expected inflation to 0.055 (the natural unemployment rate is unaffected). Graph the new Phillips curve and compare it to the curve you drew in part (a). What happens to the unemployment rate if the Fed holds actual inflation at 0.075? What happens to the Phillips curve and the unemployment rate if the Fed announces that it will hold inflation at 0.075 after the aggregate demand shock and this announcement is fully believed by the public?

c. Suppose that an earthquake (a supply shock raises the expected inflation rate to 0.095 and raises the natural unemployment rate to 0.06. Repeat part (b).