Question

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%.

Answer 1

In the top graph that follows, equilibrium initially occurs where the MP1 curve intersects the IS curve. The real interest rate equals r1 and the output gap equals zero. In the bottom graph, equilibrium initially occurs where the PC1 curve intersects the line where the output gap equals zero. The inflation rate equals -2%.

  

The Fed should reduce its target for the federal funds rate, lowering the real interest rate from r1 to r2. In the top graph, the MP curve will shift down from MP1 to MP2. The lower real interest rate causes a movement along the IS curve. The output gap changes to As a result of the change in the output gap, there is a movement along the PC1 curve and the inflation rate increases from -2% to 2%.

As the inflation rate persists at 2%, the expected inflation rate will increase from -2% to 2%, shifting the output gap Phillips curve in the bottom graph up from PC1 to PC2. The Fed would then raise the real interest rate from r2 to r1, causing the MP curve to shift back up from MP2 to MP1, returning the output gap to zero. The economy has returned to long-run equilibrium at an inflation rate of 2%.