Elucidate the impact of expected rate of return on price level and real GDP using AD-AS diagrams.
Suppose that there is an "inflation scare," that is, suppose market participants increase their expectations of future inflation.
a. With the help of AD-AS diagrams, explain the effects of an increase in the expected rate of inflation on the equilibrium value of the price level and real GDP if:
(1) The U.S. economy is initially at full employment.
(2) The U.S. economy is initially below full employment.
In your explanations, be clear about the interconnections among markets.
b. Next, explain the effects of an increase in the expected rate of inflation on the equilibrium values of the nominal interest rate and the real interest rate if:
(1) The U.S. economy is initially at full employment.
(2) The U.S. economy is initially below full employment.
c. Suppose that the Fed wanted to offset the results found in your answer to a. Explain what it would do.