Q. (IS-MP-AS with a temporary demand shock) Suppose that there is a temporary consumption boom that lasts for one period.

(a) Using the IS-MP-AS framework, explain what happens to the economy in the absence of any monetary policy action (keeps the REAL interest rate unchanged).

(i) At time 1, what would be the effect of the shock on the IS-MP-AS curve? Be sure to include graphs showing how real interest rate, output and inflation respond to the shock, and explain. (ii) At time 2, what would be the effect of the shock on the IS-MP-AS curve? Be sure to include graphs showing how real interest rate, output and inflation respond to the shock, and explain. (iii) Using your answers in a-(i) and (ii), plot how real interest rate, output and inflation will evolve over time (X-axis: time, Y-axis: real interest rate, output, inflation).

(b) Suppose you are in charge of the central bank.

(i) What monetary policy action would you take? What the short-run output will you choose and why? Using the IS-MP-AS framework, explain what would happen to the economy in this case at time 1. Be sure to include graphs showing how real interest rate, output and inflation respond to the shock, and explain.

(ii) What would happen to the economy in this case at time 2? Be sure to include graphs showing how real interest rate, output and inflation respond to the shock, and explain.

(iii) Using your answers in b-(i) and (ii), plot how real interest rate, output and inflation will evolve over time (X-axis: time, Y-axis: real interest rate, output, inflation). Also, compare your graphs of output and inflation with those from part (a).