Consider the full short-run model (IS-MP-PC). You need to draw a diagram and answer the questions below. The IS-MP-PC Model is a 2-part diagram. The top part contains the IS and MP curves. The bottom part contains the PC curve. In both cases the horizontal axis measures SRO (short-run output).

Begin by depicting the initial equilibrium (year 0). That is, draw the diagram corresponding to a situation where there are no AD shocks (a=0), the Fed sets the real interest rate equal to the MPK (r), and there are no inflation shocks (o=0). Suppose also that the initial inflation rate is 4%, which corresponds to the Fed's target inflation rate. Label the initial equilibrium as point A in the diagram, both in the top and bottom parts of the diagram. Which of the statements below is correct regarding year 0?

At the initial equilibrium, the real interest rate will be equal to the MPK and the inflation rate will be stable at 0%.

At the initial equilibrium, SRO will be zero and the inflation rate will be stable at 2%.

At the initial equilibrium, SRO will be zero and the inflation rate will be stable at 4%.

At the initial equilibrium, both SRO and the real interest rate will be equal to zero.

In year 1, a new administration announces that publicly traded companies will be required to disclose their financial information with greater detail and more clarity. As a result, there is a reduction in the uncertainty about the creditworthiness of all major companies that is reflected in a sharp drop in the spreads of corporate bonds relative to government bonds. Assuming the Fed keeps the interest rate unchanged, think about which curves need to shift in the IS-MP-PC diagram. Update the diagram and label the new equilibrium as point B (in top and bottom diagram). Which of the statements below is correct?

Borrowing costs increase and the MP curve shifts up.

Borrowing costs decrease and the MP curve shifts down.

The economy experiences an inflation shock and we move up along the PC curve.

The economy experiences an inflation shock and the PC curve shifts up.

In year 2 the Fed compares the inflation rate in year 1 to the target of 4%. If the inflation rate in year 1 is higher or lower than the target rate, the Fed adjusts the interest rate to bring the inflation rate back to the target value. What will the Fed do? Assume the IS and PC curves remain as in the previous year. Update the diagram and label the new equilibrium as point C. Which of the following statements below is correct?

Because SRO in period 1 is above 0, the Fed will shift up the PC curve.

Because the inflation rate in period 1 is below 4%, the Fed will cut interest rates to push the MP curve down.

Because the inflation rate in period 1 is above 4%, the Fed will increase interest rates to push the MP curve up.

Because SRO in period 1 is below 0, the Fed will shift down the PC curve.

PAGE 3. Draw the diagram corresponding to the questions in this section. Make sure you label equilibrium points A (year 0), B (year 1) and C (year 2). Include also a short written description . Initialize and upload a picture.