Imagine that oil prices decrease so that there is a negative supply shock ( ō= -1% ). Assume that the shock happens at t=2. Also, assume that at t=1: the inflation rate was 3% (T-1 = 3% ), the interest rate was equal to its long-run level (+1 = = 2%), and there were no shocks.
1. Initially, suppose the central bank keeps the real interest rate unchanged.
2. Suppose you are appointed to chair the Federal Reserve. Your goal is to maintain inflation at 3%. What monetary policy action would you take in this case and why?
For each case, use the IS-MP diagram and the Phillips curve to show what happens to the economy. Also, provide graphs of the real interest rate, short-run output, and inflation over time: rvs t, Y vs t, π vs t. Your graphs should show these variables for t=1,2, and 3.
