Use the AS-AD model where the central bank has an interest rate rule with a price target, PT.

it= in + alpha (Pt-PT). Assume that before any changes, the economy was in medium run equilibrium.

a. Explain why the AS curve slopes upward in price-output space and why the AD curve slopes downwards. Suppose government expenditure increases (output starts at its natural level).

b. What happens to the AD and AS curves in the short run, and what happens to the economy (output, price levels and interest rate) in the short run? Use the ADAS diagram.

c. What happens to output, price levels and the interest rate in the medium run?