A 10-mark Question about Dynamic AS-AD Model

Consider the dynamic AS-AD model. Assume the economy is at an initial equilibrium where real output is equal to its natural levelY and inflation is at its target rate. Suppose the central bank lowers its inflation target to a new level of<

Question parts

(a) (2 marks)Explain how the change in the inflation target affects the DAS-DAD curves upon impact.

(b) (2 marks)Based on your answer in part a), explain the impact effect of the change in the inflation target on actual inflation, real output, the nominal interest rate and real interest rate.

(c) (3 marks)Describe the responses of inflation, real output, the nominal interest rate and the real interest rate over time as they approach a new long-run equilibrium. Are the new long-run levels of these variables higher or lower than their initial values? Provide intuition for the dynamics.

(d) (3 marks)Explain why the slope of the DAS curve plays a crucial role in determining the size of thesacrifice ratio.