In the Solved Problem in the text, we described the outcome of policies to fight the economic downturn that arises with a price shock. With expected inflation at 4 percent and the economy operating at a zero GDP gap, use a diagram like Figure 14.3 to:

a) Show and explain the effects on output and inflation of using policies to fight the higher inflation. Be sure to consider the short-term and long-term results.

b) Show and explain the effects on output and inflation of doing nothing. Be sure to consider the short-term and long-term results.

c) Of the two possible responses—fight inflation or do nothing—which policy response would you favor? Justify your answer.