The following exercise assumes that the economy responds as predicted by the New Keynesian version of the FE-IS-LM model.
In this question we will analyze the following statement, and show what would happen if the advice given was followed by the Fed: “Higher consumer confidence increases aggregate demand. To offset this we must decrease the money supply. Then the price level won't need to adjust to restore equilibrium, and we'll prevent inflation.”
Consider that an increase in of consumer confidence corresponds to an increase in households' expectations about their future income.
a. State what happens to the FE and IS curves (see problem set 7). Explain with the help of graphs what happens in the short-run to the expected real interest rate, output and employment, consumption, savings and investment (If necessary assume that the shift of the FE line is smaller than the shift of the IS curve).
b. Explain with the help of graphs how the economy converges to the short-run general equilibrium after the shock.
c. Explain with the help of graphs what the Fed should do in order to avoid a change in output in the short-run.
d. What happens to the expected real interest rate, output and employment, consumption, savings, investment and prices once prices become perfectly flexible (Assume that the fed has implemented the recommended policy)?
e. Once prices become perfectly flexible, what should the Fed do in order to maintain prices constant?
f. Use your findings to comment the statement.