In a certain economy the expectations-augmented Phillips curve is

=^e2(u)

= 0.06

a. Graph the Phillips curve of this economy for an expected inflation rate of 0.10. If the Fed chooses to keep the actual inflation rate at 0.10, what will be the unemployment rate?

b. An aggregate demand shock (resulting from increased military spending) raises expected inflation to 0.12 (the natural unemployment rate is unaffected). Graph the new Phillips curve and compare it to the curve you drew in Part (a). What happens to the unemployment rate if the Fed holds actual inflation at 0.10? What happens to the Phillips curve and the unemployment rate if the Fed an- nounces that it will hold inflation at 0.10 after the aggregate demand shock, and this announcement is fully believed by the public?

c. Suppose that a supply shock (a drought) raises expected inflation to 0.12 and raises the natural unemployment rate to 0.08. Repeat Part (b).