solution

Answer the following questions:

(1) Assume that the expected inflation rate for period t+1 (at period t) still equals 2% after consumers’ confidence increases. How do the short-run equilibrium output and actual inflation rate in period t+1 compare to the equilibrium output and actual inflation rate in period t if the central bank does not change the real policy rate from period t to period t+1? (10%) Draw diagrams to show the movement from period t to period t+1 using the IS-LM-PC model with words.

(2) (Continued from the above) Suppose that the increase of consumers’ confidence at period t+1 increases the change of inflation rate (i.e., 11t+1 – TIe) that is equal to 5%. What is the actual inflation in period t+1? Moreover, in period t+2 consumer’s confidence remains high (equal to that in period t+1) and the central bank does not change the real policy rate. What will be the actual inflation rate at period t+2? (10%) Draw IS-LM-PC model to explain with words.