Assume that the central bank follows the following

Reference no: EM13374911

Assume that the central bank follows the following simplified version of the Taylor rule:

1415_Graph the monetary policy rule.png

(a) What implicit weight is placed on the inflation target under this rule? Discuss. Draw an IS-MP diagram but instead of the usual MP curve, graph the monetary policy rule. You might label this curve MPT for the simplified Taylor rule.

(b) Now consider the effect of a negative aggregate demand shock in the IS-MPT diagram. Compare and contrast the effect of this shock on the economy in the standard IS-MP diagram (without policy response to the shock) versus the IS-MPT diagram. Is there a difference?

(c) Find the equilibrium values of the short-run output and the real interest rate from the IS-MPT model. Explain how these equilibrium values depend on the parameter.

(d) Economists refer to the result in the IS-MPT diagram as "crowding out". What gets crowd out and why?

(e) Briefly compare and contrast the economic effects of a temporary negative aggregate demand shock lasting for 2 periods in the standard AS/AD model (of the textbook) with that in the AS/AD model under the simplified Taylor rule above. Assume that in both cases the economy starts in the same long-run equilibrium.

Reference no: EM13374911

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