Assume that policy makers are using the Taylor rule as a basis for policy changes, as specified in Equation 1.

Under each of the following scenarios, show how the real interest rate, output, and inflation behave in both the short and long run. Use an IS graph and the AD/AS graph, and show the Taylor rule in an MP curve graph.

a) In 1973, the United States experienced an unexpected slowdown in productivity, which reduced potential output.

b) The U.S. economy was experiencing high inflation in the late 1970s. To combat this high inflation, the Fed under Chairman Paul Volcker significantly reduced the target inflation rate.

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x=2.0 + (-) + (Y - Y YP) (1)