1. Starting with the economy in long-run equilibrium, use the aggregate demand-a

Question

1. Starting with the economy in long-run equilibrium, use the aggregate demand-aggregate supply framework to illustrate what would happen to inflation and output in the short run if there were a rise in consumer confidence in the economy. Assuming the central bank takes no action, what would happen to inflation and output in the long run?

Also, assuming the central bank maintains its existing inflation target, illustrate the impact on the monetary policy reaction function and on equilibrium inflation and output both in the short run and in the long run.

(I just need the answer for the second part of the question)

Explanation / Answer

The move out of the demand curve in the first paragraph would cause a long term rise in the price level. To combat it the Fed would tighten monetary policy and reduce the money supply, causing interest rates to go up, investment to go down and the demand curve returning to its original position and the price level to return to its initial condition.

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