Fed policy is centered around the neutral rate of interest. This can sometimes create trouble in

satisfying the Fed's dual mandate. Ypispania is an economy whose short run equilibrium is

determined by the equations

IS: Y = 150 - 10r

MP(): r = 1 +

and

AD: Y = 140 - 10

SRAS: = 4

Notice that the economy has a sticky-price SRAS. Finally, Yspispania has a version of Okun's Law

that says (Y -Y^-- ) = -5(U - U_N),

where U_N = 6. The economy starts in a long run equilibrium

a. When we say the Fed has a "dual mandate", what do we mean?

b. What is Ypispania's LRAS? What's its initial neutral rate of interest?

c. There is a negative shock to consumer confidence, and the IS curve shifts inwards to Y = 130 - 10r.

i. In the short run before the Fed can respond, how much does unemployment change as a result of the IS shock?

ii. What is the new neutral rate of interest?

d. Draw a graph of how AD, SRAS, and LRAS shift as IS and MP change in part (c). Describe

how inflation, output, and unemployment change along the way. (You don't need to perform

additional calculations for this question.)

e. Now consider a different shock. Start as in the initial setup, but then there is a cost shock. The

SRAS curve shifts to become

= 6.

i. In the short run before the Fed can respond, how much does unemployment change as a

result of the SRAS shock?

ii. What is the new neutral rate of interest?

f. Draw a graph of how AD, SRAS, and LRAS shift as IS and MP change in part (e). Describe

how inflation, output, and unemployment change along the way. (You don't need to perform

additional calculations for this question.)

g. Look at your answers and graphs to parts (d) and (f). In each, did the Fed fulfil its dual mandate?