Imagine that, due to the conflict between Russia and Ukraine, oil prices increase so that the economy experiences the shock o=3%.

Assume that the shock happens at t=2.

Also, assume that:

• at t=1: the inflation rate was 8% (t=1=8% ), the interest rate was equal to its long-run level (rt=1=r=2% ), and there were no other shocks.
• Use the following values for the parameters: b=2 , v=1, r=2%.

For each of the following cases:

• CASE A: Suppose the central bank keeps the real interest rate unchanged.
• CASE B: Suppose now that the central bank increases the rate to 4% at t=2, then it reduces the rate back to 2% at t=3.

Answer the following:

• Q1 (10 points). Use the IS-MP diagram and the Phillips curve to show what happens to the economy at t=2.
• Q2 (10 points). Provide graphs of the real interest rate, short-run output, and inflation over time: rtvs t, Y~tvs t, t vs t.
  • Your graphs should show these variables for t=1,2, and 3.
  • You should provide the numerical values of rt, Y~t, t at each t=1,2, and 3 (use the parameters to get exact values, if you cannot get the exact values show qualitatively how they will move for partial credit).

Now, imagine that the Central Bank cannot change the rate. Suppose instead that you can implement fiscal policy. Answer the following:

• Q3 (3 points). What fiscal policy action would you take? Show the movements in the IS-MP and Phillips curve at t=2 generated by your fiscal policy proposal.
  • No need to show numerical values here.
• Q4 (2 points). Does your answer to question (3) depend on whether the Ricardian equivalence holds? Explain.