an alternative assumption about the behavior of inflation behavior is that inflation expectations are anchored. This problem asks you to analyze the implications of anchored inflation expectations for the 1iquidity trap.

b. Suppose that the economy is initially in long-run equilibrium with n: = II:* and i > 0. Now suppose there is a permanent backward shift of the IS curve such that when II: = 7|:*, the IS and MP curves intersect on the at part of the MP curve. Assume also that the behavior of ination is described by our assumptions for the case of anchored expectations at the end of Section III. i. How, if at all, will this shift affect the AD curve? ii What will happen to this economy over time? Will output ever return to 7'? Will output and ination fall without bound? (Hint: see the discussion of TEST-BABY at the end of Section III.)