Suppose that the Central Bank follows a monetary policy rule as discussed in the textbook and lectures. The country is in the long-run macroeconomic equilibrium. Suppose that in period 1 the country experiences a 3% inflation shock that lasts only for one period, so in periods 2, 3 and so on there is no inflation shock.

The governors of the Central Bank change their monetary policy rule as follows:

Note that It is the nominal interest rate.

Derive the new AD curve. How does short run output respond to inflation along the AD curve?

How will the economy respond to a one time inflation shock? Discuss periods 1 and 2.