Use the information contained in problem 2 to answer this problem. Suppose that monetary policymakers do not want to see a permanent rise in the inflation rate result from the increase in government spending. So following the increase in government spending, they take actions to reduce the growth rate of nominal GDP.
(a) What is the expected inflation rate in the second period? Compute points on the new short-run Phillips Curve for the second period when the inflation rate equals 0, 1, 2, 3, 4, and 5, given the expected inflation rate in the second period. Graph the short-run Phillips Curve for the second period.
(b) If monetary policymakers wish to reduce the rate of inflation to 2 percent in the second period, what must they reduce the growth rate of the nominal GDP to in the second period and what is the output ratio at the end of the second period, given the monetary contraction?
(c) What is the expected inflation rate in the third period? Compute points on the new short-run Phillips Curve for the third period when the inflation rate equals 0, 1, 2, 3, 4, and 5, given the expected inflation rate in the third period. Graph the short-run Phillips Curve for the third period. In order to maintain an inflation rate of 2 percent in the third period, explain why the growth rate in nominal GDP would have to be greater than 2 percent in the third period. What would the growth rate of nominal GDP have to be the long run in order to maintain an inflation rate equal to 2 percent?
Suppose that monetary policymakers have been able to establish a record of maintaining inflation at 2 percent. As a result, workers and employers expect that any increase or decrease in the inflation rate is only temporary because monetary policymakers take steps to change the growth rate of nominal GDP so as to quickly restore inflation to its long-run equilibrium level of 2 percent.
(d) Given the expectation that any increase or decrease in the inflation rate is only temporary, does the short-run Phillips Curve shift up or down when the actual inflation rate deviates from the expected inflation rate?
(e) Given your answer to part d, what must monetary policymakers reduce the growth rate of the nominal GDP to in the second period in order to reduce the inflation rate to 2 percent and what is the output ratio at the end of the second period, given the monetary contraction? What would the growth rate of nominal GDP have to be in the third period in order to maintain an inflation rate of 2 percent?
(f) Explain why your answers to parts b, c, and e are different.