Suppose the Fed is concerned that deflation will harm the economy over the long run. Use the IS–MP model (including the Phillips curve) to analyze how the Federal Reserve would fight deflation.
a. Use an IS–MP model graph to show long-run macroeconomic equilibrium with a deflation rate of 2%.
b. If the Fed wants the economy to return to a long-run equilibrium with an inflation rate of 2%, how should it change its target for the federal funds rate? Show the effects of this change in the target for the federal funds rate on an IS–MP graph, including the Phillips curve. What happens to the output gap and to the inflation rate?
c. Use an IS–MP graph, including the Phillips curve, to illustrate how the economy returns to long-run equilibrium at the higher inflation rate.