Suppose the Fed is concerned that deflation would harm the economy over the long run. Use the IS-MP model(including the output gap Phillips curve) to analyze how the Federal Reserve would fight deflation.

Use an IS-MP model using the output gap version of the Phillips curve to show long-run macroeconomic equilibrium with a deflation rate of 2%.

1.) Using the line drawing tool, draw a Phillips curve that illustrates a long-run equilibriurm at a deflation rate of

2%.

Properly label your curve.

2.) Using the point drawing tool, plot the long-run equilibrium point.

Carefully follow the instructions above, and only draw the required objects.

If the Fed wants the economy to return to a long-run equilibrium with an inflation rate of 2%, how should it change its target for the federal funds rate?

The Fed should

▼

 

increase

reduce

its target for the federal funds rate, shifting the

▼

 

MP curve up

IS curve inward

MP curve down

IS curve outward

and

▼

 

lowering

raising

the real interest rate. This will

▼

 

decrease

increase

the output gap and

▼

 

decrease

increase

the actual inflation rate along the output gap Phillips curve to 2%.

How does

the

economy return to long-run equilibrium at the higher inflation rate?

As the inflation rate persists at 2%, the

▼

 

actual

expected

inflation rate will

▼

 

decrease from 2% to 0%

increase from -2% to 0%

increase from -2% to 2%

decrease from 2% to -2%

, shifting the output gap Phillips curve

▼

 

down

up

. The Fed would then

▼

 

raise

lower

the

▼

 

expected

real

interest rate, shifting the

▼

 

MP curve up

IS curve outward

MP curve down

IS curve inward

and returning the economy to potential GDP.