The dynamic aggregate demand curve is given by: Y₁ = Y* − 4(π, − πª) + ε₁ The dynamic aggregate supply curve is given by (inflation expectations are backward looking): T₁ = R₁_1 + 1/ (Y₁ - Y*) + v₁ In period 1 the economy was in equilibrium and the rate of inflation was at the target level when a positive demand shock hit the economy, &-12. The shock was short-lived, that is, from period 2 onwards ε =0. a) Calculate the difference between actual and potential output (i.e., output gap) AND the difference between actual inflation and inflation target in period 1 when the shock hit the economy. b) Calculate the difference between actual and potential output (i.e. output gap) AND the difference between actual inflation and inflation target in period 2 when the shock disappeared. c) Suppose that in response to a positive demand shock the central bank changed the target rate of inflation in order to maintain output at the potential level and inflation unchanged in period 1. Calculate the change in inflation target in period 1 necessary to achieve this objective.
