Consider the IS-MP-PC Model. Draw a two-part diagram. At the top draw the IS-MP curves where the initial equilibrium is such that the real interest rate equals the MPK and short-run output (SRO) is at its long-run value. Label as Point A. In the bottom diagram draw the Phillips curve. Label as Point A the point depicting the change in the inflation rate that results when output is at its long-run value in the absence of inflation shocks. Suppose that the widespread switch to online shopping lowers the profit margins of businesses and impacts their price-setting strategies. Make a prediction about the short-run economic effects of this inflation shock using the IS-MP-PC model. Add the new equilibrium to your diagram and label it Point B. Choose the correct answer to each question.

The switch to online shopping will

shift the MP curve up. Short-run output and inflation will both fall.

shift down the PC curve. Inflation will fall as a result.

shift up the PC curve. Inflation will rise as a result.

shift the IS curve to the left. Short-run output and inflation will both fall.

shift the IS curve to the right. Short-run output and inflation will both increase.

Suppose that before the rise of online shopping the inflation rate was 2% and assume this was the rate targeted (i.e. preferred) by the Fed. Now consider the rate of inflation in the new equilibrium depicted as point B in your diagram. Assume also that the Fed is just concerned with returning the inflation rate back to 2% whenever it deviates from this target. Given this information, is the Fed happy with the equilibrium at point B? If not, what will be the reaction of the Fed? Pick the best answer from the choices below. Also draw the new equilibrium in the diagram and label it Point C.

The Fed will lower the interest rate to shift the Phillips curve down.

The Fed will lower the interest rate to create inflation.

The Fed will raise the interest rate to lower inflation.

The Fed will lower the interest rate to shift the Phillips curve up.

The Fed will adopt fiscal stimulus to stimulate investment and short-run output.