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Question 2. AD-AS Analysis with an Alternative Policy Rule. This question will have you derive a version of the aggregate demand curve under alternative assumptions about how the Fed conducts policy. Assume that the IS curve assumes the usual form: Y=1mpcCmpcT+I+G1mpcdr where Y is output, r is the real interest rate, and the remaining parameters utilize the same notion that we used in class. Suppose that the Fed's actions are summarized by the following monetary policy curve: r=r+(YYp)+ where Yp is potential output, is the inflation rate, and r is the autonomous component of monetary policy. Assume that the short-run aggergate supply curve assumes the usual form: =e+(YYp)+ where e is expected inflation, and is an inflationary shock. a) Why would the output gap enter into the Fed's moetary policy rule? Would you expect to be positive or negative, why? How would you interpret and ? b) Combine the IS curve and the monetary policy curve to obtain an aggregate demand curve. That is, express output Y as a function of inflation . (This expression will also contain the exogenous quantities C,I,G,T, and r, as well as potential output Yp and the parameters mpc,d,, and lambda.) c) How does affect the sensitivity of Y to changes in ? If increases by one, then by how much does Y change? d) Suppose that the aggregate demand curve and the aggregate supply curve intersect at a value of Y that's greater than Yp. What curve (or curves) shift to return the economy to a long-run equilibrium, and why? Draw a graph of aggregate demand and aggregate supply to show how the economy adjusts. What happens to inflation and output

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