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Consider the following 3-equation model:
where Y is output, π is inflation, π e = π ∗ = 2, and Y ∗ = 100.
Expected inflation is π e , and Y - Y ∗ is the output gap. The variable r CB is the interest rate set by the central bank. We may interpret π ∗ as the central bank's inflation target. Government expenditure, G, and net taxes, T, are both given and set by the government.
(a) Which of the above equations is the IS curve, and which is the Taylor rule? Provide a brief economic explanation for the positive relationship between π and Y - Y ∗ in Equation (5).
(b) Find numerical solutions for inflation, output and interest rates when G = T = 10.
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