2. Suppose that the economy begins in long-run equilibrium: output is at potential and, as a result, inflation is steady. Now, suppose there is a permanent upward shift of the Federal Reserve's reaction function.

a. What does this change in the reaction function imply that the Fed will do to the real and nominal interest rates in the short run? Will this involve the Fed buying or selling government bonds?

b. What will be the short-run effect of the change on GDP?

c. Sketch how GDP returns to its potential level. (Hint: What will happen to

inflation after a while? How will the Federal Reserve respond to that?)

d. When Y is back to Y*, is inflation higher, lower, or the same as it was initially (or is it not possible to tell)?

e. When Y is back to Y*, is the real interest rate higher, lower, or the same as it was initially (or is it not possible to tell)?