2. Suppose that the long-run real interest rate is 1% and the Fed has an inflation target of 2%. (a) Suppose that the economy starts out in period 0 in long-run equilibrium. Draw the AS-AD diagram corresponding to the equilibrium in period 0, labeling the curves AS0 and AD0. Indicate on your graph the numerical values for the variables on the horizontal and vertical axis in the initial equilibrium. What is the initial value for the nominal interest rate. (b) Assume that in period 1, oil prices fall resulting in a one-time shock to o in period 1. Draw the AS and AD curve for period 1, labeling these as AS1 and AD1. Assuming adaptive expectations, does the nominal interest rate go up, down or stay the same between period 0 and period 1 ? How do inflation, short-run output, and the real interest rate respond? 23 (c) Beginning in period 2, o returns to its long-run value. In the same diagram, show how aggregate demand and aggregate supply shift in period 2 . What happens to short-run output and inflation, relative to period 1 ? (d) Explain how the economy evolves gradually over time from period 3 onward. In the long-run, what happens to output and inflation? 2. Suppose that the long-run real interest rate is 1% and the Fed has an inflation target of 2%. (a) Suppose that the economy starts out in period 0 in long-run equilibrium. Draw the AS-AD diagram corresponding to the equilibrium in period 0, labeling the curves AS0 and AD0. Indicate on your graph the numerical values for the variables on the horizontal and vertical axis in the initial equilibrium. What is the initial value for the nominal interest rate. (b) Assume that in period 1, oil prices fall resulting in a one-time shock to o in period 1. Draw the AS and AD curve for period 1, labeling these as AS1 and AD1. Assuming adaptive expectations, does the nominal interest rate go up, down or stay the same between period 0 and period 1 ? How do inflation, short-run output, and the real interest rate respond? 23 (c) Beginning in period 2, o returns to its long-run value. In the same diagram, show how aggregate demand and aggregate supply shift in period 2 . What happens to short-run output and inflation, relative to period 1 ? (d) Explain how the economy evolves gradually over time from period 3 onward. In the long-run, what happens to output and inflation