During the nearly three decades from the 1980s to 2007, developed economies and, especially, the US experience low volatility in inflation, employment and economic growth. Thus, in historical context, business cycles were more moderate, expansions more prolonged and recessions milder. One of the possible explanations of the Great Moderation is based on the institutional change in monetary policy, where a policy regime based on inflation as the target, the interest rate as the instrument, and the independence of the central bank becomes widespread. This policy regime, it is argued, had beneficial effects on the formation of expectations giving confidence about the capacity and will of the central bank to maintain the inflation rate around the target. This allowed a more moderate response of monetary policy to inflationary shocks. It also reduced the need of central banks to cool the economy facing too fast aggregate expenditure growth. Go to the macroeconomic simulator accompanying the Carlin and Soskice textbook. Use the closed economy version and make sure you start from scratch, that is all shocks are reset.

a) Apply a 3% inflationary shock. Save your data. Now, change the value of x (degree of inflation inertia/credibility of the central bank) to 0.5 and apply again the same shock. Save your data. Compare both scenarios in terms of the volatility (that is, degree of deviation with respect to equilibrium) of output and inflation, and the policy response. Explain how well your results correspond to the text above. (6 points)

b) Apply a temporary 3% positive demand shock. Save your data. Now, change the value of x (degree of inflation inertia/credibility of the central bank) to 0.5 and apply again the same shock. Save your data. Compare both scenarios in terms of the volatility (that is, degree of deviation with respect to equilibrium) of output and inflation, and the policy response. Explain how well your results correspond to the text above. What conclusions do you draw? (6 points)