C2. Dynamic AS-AD model. Consider a dynamic AS-AD model with DAS curve TH+ = Tt-1+0.4(Y4 100) and with DAD curve Y4 = 100 0.5(T7 3) + 0.54 The output equation is Y= 100 (rt 2) + t (a) Solve for inflation as a function of lagged inflation and demand shocks. Use a diagram to illustrate how inflation depends on lagged inflation. If inflation deviates from its target level, does inflation return to its target according to the equation you have derived? Explain. (2 points) Suppose that the economy is initially in the long run equilibrium and then at time t = 1 the government cuts its spending by having 1 = -3 for just one period. That is, 1 = -3 and Et = 0 for all subsequent t. (b) Compute the values of output, inflation, nominal interest rate and real interest rate at time t = 1. (2 points) (c) With the help of a diagram, explain qualitatively the subsequent time paths of output and inflation after the negative demand shock ends. Carefully label your diagram. How does monetary policy respond to the negative demand shock? Explain. (3 points) (d) Now suppose that the negative demand shock is permanent. With the help of a diagram, explain how a permanent negative demand shock affects the economy over time. Would inflation return to its target and output return to its natural level in the long run? Why or Why not? (2 points) (e) Following part (d), what could the central bank alter to achieve the original long run equilibrium? Explain. (1 point) C2. Dynamic AS-AD model. Consider a dynamic AS-AD model with DAS curve TH+ = Tt-1+0.4(Y4 100) and with DAD curve Y4 = 100 0.5(T7 3) + 0.54 The output equation is Y= 100 (rt 2) + t (a) Solve for inflation as a function of lagged inflation and demand shocks. Use a diagram to illustrate how inflation depends on lagged inflation. If inflation deviates from its target level, does inflation return to its target according to the equation you have derived? Explain. (2 points) Suppose that the economy is initially in the long run equilibrium and then at time t = 1 the government cuts its spending by having 1 = -3 for just one period. That is, 1 = -3 and Et = 0 for all subsequent t. (b) Compute the values of output, inflation, nominal interest rate and real interest rate at time t = 1. (2 points) (c) With the help of a diagram, explain qualitatively the subsequent time paths of output and inflation after the negative demand shock ends. Carefully label your diagram. How does monetary policy respond to the negative demand shock? Explain. (3 points) (d) Now suppose that the negative demand shock is permanent. With the help of a diagram, explain how a permanent negative demand shock affects the economy over time. Would inflation return to its target and output return to its natural level in the long run? Why or Why not? (2 points) (e) Following part (d), what could the central bank alter to achieve the original long run equilibrium? Explain. (1 point)