The economy begins at potential GDP with an inflation rate of 2 percent. Suppose a price shock pushes inflation up to 6 percent in the short run, but the Fed views the effect on inflation as temporary. It expects the inflation adjustment line to shift back down to 2 percent the next year, and in fact, the inflation adjustment line does shift back down.

a. If the Fed follows its usual policy rule, where will real GDP be in the short run? How does the economy adjust back to potential?

b. Now suppose that because the Fed is sure that this inflationary shock is only temporary, it decides not to follow its typical policy rule, but instead maintains the interest rate at its previous level. What happens to real GDP? Why? What will the long-run adjustment be in this case? Do you agree with the Fed’s handling of the situation?