Question $1$

$10$ pts

Suppose the economy is currently operating at Full$-$Employment $($i$.$e$.Y=Y_m),$ and inflation is at the Federal Reserve's preferred level, $i^{**}.$ Use the Phillips Curve model from class to answer the following questions:

A$.$ Suppose that expected inflation decreases. According to our Phillips curve relationship, what happens to actual inflation? If the Fed does not change its target nominal interest rate, $R^{**},$ what happens to the real interest rate, $r?$

B$.$ Given your answer to part $($a$),$ draw the effects of this change on the two Phillips curve graphs. Does the economy have an output gap? Where is inflation relative to the Fed's target rate?

C$.$ In this situation, what do you expect the Fed to do with its target for the Federal Funds Rate? How would they accomplish this? Show and describe the Fed's actions in both cases $($i$)$ sufficient reserves, and $($ii$)$ insufficient reserves.