The text analyzes the case of a temporary shock to the demand for goods and services. Suppose, however, were to increase permanently. What would happen to the economy (and to inflation in particular) over time?

a) Illustrate your answer with a DAD-DAS diagram showing the initial equilibrium, the short-run equilibrium after the positive demand shock, and the new long-run equilibrium. [Draw your diagram such that the economy was initially in long-run equilibrium before the demand shock.]

b) To make your answer precise, solve for the new long-run equilibrium by deriving expressions for the DAD-DAS equilibrium , , and in terms of , , , , , , and , which now is permanently positive rather than zero. Assume that =0 in long-run equilibrium, and that the natural level of output is unchanged by this demand shock. Summarize your results in words; in particular, what has happened to the target rate of inflation?

c) How might the central bank alter its policy rule in order to ensure that the economys long-run equilibrium is unaffected by this negative demand shock? Explain in words what sorts of actions the central bank would take.

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