Go back to exercise 3 and explain what happens in the full short-run model (including the Phillips curve and allowing the economy to evolve over time). Do this for both parts (a) and (b), and be sure to provide graphs of output and inflation over time.
Exercise 3
Using the IS-MP diagram, explain what happens to the economy if there is a temporary consumption boom that lasts for one period.
(a) Initially, suppose the central bank keeps the nominal interest rate unchanged.
(b) Suppose you are appointed to chair the Federal Reserve. What monetary policy action would you take in this case and why? Refer to the IS-MP diagram.