question 2,

The policymakers believe that there is a need to increase an inflation target (say, in order to be able to use conventional monetary policy in the future.) Assume that initially the inflation target is 2% and the economy is in the long-run equilibrium. In period one the ination target is increased to 4% (and this increase is announced). You are asked to analyse the effect of this increase in the ination target on the economy using the short run model and the AS-AD model. IScurve:17t=ciE(Rtf),where&=0,b= 1, i=2. Phillips curve: t = 1r+ 17?} + 6, where 17 = 0.5, 5 = 0. Fisher equation: R. = it It}? For the AS/AD model assume the monetary policy rule: Rt 2 1" + Ort fr), wherer = 0.5, 17 = 2. 2. Now, consider the AS/AD model where the central bank sets the interest rate following the monetary policy rule. a) Derive the AD schedule with parameter values inserted for periods 0 and 1. (2 marks) b) Assuming the backward-looking expectations, analyse the effects of an increase in the ination target on short-run output, ination and the real interest rate in periods 1 and 2 and explain how the economy would adjust to the long-run equilibrium. Use the well labelled AS/AD diagram in your answer (note, that you don't have to calculate the values of the variables). (5 marks) c) How would your answer to b) change in the case of the rational expectations, in? = fr