Suppose the central bank, instead of following the rule r = r(Y, ?), has a target level of inflation.

Suppose the central bank, instead of following the rule r = r(Y, 7), has a target level of inflation. Specifically, it sets r according to r = LR + b(7 - 7*). Here LR is the real interest rate when the economy is in long-run equilibrium, that is, it is the real interest rate that cause the loan market to be in equilibrium when Y = Y. In addition, w* is the central bank's target level of inflation, and b is some positive parameter. This rule states that the central bank raises the real interest rate above its long-run level when inflation is above its target and lowers it below its long-run level when inflation is below its target. a. With this monetary policy rule, is the MP curve upward-sloping, flat or downward-sloping? Explain. b. Is the AD curve upward-sloping, flat, or downward-sloping? On the AD curve, what level of Y is associated with 7 = *? Explain. C. Suppose some development raises LR but does not change Y. How, if at all, does this affect the AD curve? d. Assume the economy starts in a situation where 7 = 7* and Y = Y. Describe the immediate effects of each of the following developments on output, inflation and the real interest rate: i. Government purchases rise. 2 ii. There is an unfavorable inflation shock. iii. The central bank reduces its inflation target, *