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1.
A. Using the IS-MP-FE and AD-A-LRAS model, GRAPH an economy operating at a point
where output is at its full employment level (Y=YFE), the real rate of interest is at its natural rate
(r=rN) and is at the desired rate of inflation (Hint: This is a point of GE, general equilibrium)
B. Starting from a position of GE, suppose the economy is hit by excessive optimism. In other
words, people expect higher future income and firms expect higher future marginal product of
capital. However, the central bank recognizes that there was no change in the level of full
employment output or in their target for inflation. What would the central bank do to keep
these variables operating at these desired levels? Illustrate your answer to this question with a
new graph which shows the initial GE, what excessive optimism does to the graph, and how the
central banks response keeps output and inflation at desired levels.
C. Starting from a position of GE, assume there is a technological improvement. Suppose the
central bank recognizes precisely the change in the level of full employment output that has
occurred, and there is no change in the target for inflation. What would the central bank do to
keep these variables operating at these desired levels? Illustrate your answer to this question
with a new graph which shows the initial GE, what the change in technology does to the graph,
and how the central banks response keeps output and inflation at the desired levels.
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