Monetary policy and inflation
a. Assume that the monetary authority initially wants to create inflation of 1% each year, that is, have prices rise every year at this rate. Use the AS-AD graph for the monetary misperceptions model to show what this policy would look like in a long-run equilibrium when everyone anticipated the policy. Describe the behavior of the money supply, the price level, expected price level, and output in words.
b. Draw a Phillips curve consistent with a 1% inflation rate and label the long-run values for inflation and the natural rate of unemployment? What is the expected rate of inflation in the long-run equilibrium?
c. Now, assume that a new government is elected and that it believes that it can reduce unemployment at the cost of accepting a higher rate of inflation. Use AS-AD curves in the monetary misperceptions model to show how it would try to achieve this result and what the effect on money growth, inflation, and output would be in the short run (before inflationary expectations adjust) and in the long run (after inflationary expectations adjust).
d. Illustrate your result in part c using the Phillips Curve you drew in part b. Label the equilibrium point achieved before expectations adjust 1 and the equilibrium afterwards 2. Explain below any curve shift.