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Problem Set 2 Chapter 13, Questions 3, 5

Chapter 18: Questions 1, 2.

Additional Questions 1. As the central bank raises the real interest rate, output falls below potential. The increase in r is graphically shown as a leftward movement along the AE curve (AE does not shift). The Phillips curve shifts up because of the supply shock. Because of the drop in output after the partly accommodative policy, inflation rises by less than the supply shock. The inflation rate will be permanently higher, but by less than the supply shock.

2. The expectation of a higher interest rate is already built into all longer term rates (see expectations theory). If the CB surprises bond traders by keeping rates constant, then longerterm rates will have to reflect lower interest rates and will therefore fall. So keeping the rate constant will result in lower longer-term rates because of the surprise effect.

3. a.

An adverse supply shock does not shift the AE curve. With constant real interest rates, aggregate expenditures are unchanged after the supply shock. Output is constant and remains at potential, but the inflation rate will permanently rise in response to the shift in the Phillips curve. Because of the supply shock, actual inflation will exceed expected inflation in 2020. People revise their expectations to the higher observed inflation rate. The Phillips curve will have permanently shifted, resulting in higher inflation at the potential output level. The AE/PC model with time lags reacts to the supply shock in the same way as an economy without time lags. Let’s assume that the central bank did not anticipate the supply shock and that the supply shock occurs in 2020 only. Given those assumptions, the central bank cannot prevent inflation from rising temporarily in an economy with time lags. Even if the central bank increases real interest rates in 2020, after it

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