Problem 2.5. Consider the economy presented in Problem 2.4 and assume that there was no inflation

(i.e. prices were stable) at equilibrium and that households did not expect it in the future. Analyze how

the economy will react to an exogenous price shock (e.g. a global increase in oil prices) that will cause

a one-off jump in prices by 10% in the first year.

a) Calculate the paths of inflation, GDP and prices in the following years. After how many years will the

economy (approximately) return to equilibrium?

b) Analyze the reaction of the economy in a situation where the central bank increases the nominal

money supply by 5% in the first year, so as to mitigate the effects of nominal money demand growth.

How long will it take the economy to recover this time?

c) How quickly will the economy return to equilibrium if the central bank keeps the real money supply

unchanged?

d) Compare the final new price levels in equilibrium in points (a)-(c). What is the difference?

e) How would your answers differ, if inflation expectations in the economy were adaptive

(e.g.

= 0,41)?

f) Why does the central bank sometimes decide to tighten monetary policy amid a large price shock?

Problem 2.6. A simple Taylor Rule can be described by the equation:

= + + ,

+ , ( )

Assume that the inflation target is 2%, the natural real interest rate in the economy is 1%, and the output

gap is closed.

a) Using the Taylor rule, calculate what the optimal interest rate should be if, as a result of a price shock,

inflation exceeds the target by 2 percentage points.

b) Now assume that due to the price shock, GDP will drop 5% below its potential level. How should the

central bank react in such a situation?

c) What alternative monetary policy tools can the central bank use if Taylor rule implies that it should

cut interest rates below zero.