Suppose the Fed is concerned that deflation would harm the economy over the long run. Use the IS-MP model (including the output gap Phillips curve) to analyze how the Federal Reserve would fight deflation. Use an IS-MP model using the output gap version of the Phillips curve to show long-run macroeconomic equilibrium with a deflation rate of 2%. 1.) Using the line drawing tool, draw a Phillips curve that illustrates a long-run equilibrium at a deflation rate of 2%. Properly label your curve. 2.) Using the point drawing tool, plot the long-run equilibrium point. Carefully follow the instructions above, and only draw the required objects.

If the Fed wants the economy to return to a long-run equilibrium with an inflation rate of 2%, how should it change its target for the federal funds rate? The Fed should --its target for the federal funds rate, shifting the and lowering raising the real interest rate. This will decrease increase the output gap and increase decrease the actual inflation rate along the output gap Phillips curve to 2%.