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Question 4: Demand shocks and monetary policy. For this question begin by setting up the IS-LM-PC model to describe an economy in medium- run equilibrium (i.e. Y=Yn and inflation is at the inflation target). a. There are tax cuts in period t, and the central bank does not change the real policy rate. Show the effect of these tax cuts on the short-run equilibrium in an IS-LM-PC diagram. b. Assume that inflationary expectations are adaptive. If the central bank leaves the policy rate unchanged, what happens to inflation in period t+ 1? If the central bank still doesn't react, what happens to inflation in period t+2? c. Now assume that inflationary expectations are anchored. If the central bank leaves the policy rate unchanged, what happens to inflation in period t+1? If the central bank still doesn't react, what happens to inflation in period t+2? d. Suppose that in period t+3, the central bank changes the policy rate to bring the economy to potential output and back to 2% inflation. i. Does the central bank increase or decrease the policy rate? ii. How will the central bank policy differ in (b) and (c)? Why