IS-MP + Phillips Curve (Case C)

Imagine that, due to the lockdown, consumption demand by households decreases generating a drop ina

C

. Assume that this shock happens at t=3 and only lasts one period.

1.Analyze graphically, using the IS-MP and the Phillips curve, what happens to short-run output and inflation at t=3, for each of the following cases:

a) (5 points) The Central Bank keeps the interest rate at the long-run levelr

.

b) (5 points) The Central Bankdecreasesthe interest rate at t=3.

2.Now, show what would happen to: theinterest rate (r

t

),short-run output(Y

~t

), andinflation (

t

)over time. You must show what happens for each of the cases:

a) (5 points) Assume Central Bank keeps the rate atr

for all periods.

b) (5 points) Assume Central Bankdecreasesthe rateonlyat t=3 (it goes back tor

at t=4,5).

• You should show what each of the variables is at each periodfrom t=1 to t=5.
• For this question assume that before the shock (t=1,2): the interest rate was at its long-run level (r
• t=r
• ), output at its potential (Y
• t=Yt
• ), and inflation was 5% (
• t=5%
• ).
• You should provide qualitative answers similarly to the problem set (no numerical calculations needed).