We have the following information for an economy: Y = 380-500r IS equation: Phillips Curve: _e TT - 7 = 200(Y-Y) Y Yn = Natural Rate of Output: Yn = 400 Real rate of interest: r=i-te, where tº is the expected rate of inflation. The initial rate of inflation, To = 2%. (A) Calculate the natural rate of interest. (B) The economy is in the middle of a recession and the Fed wants to adjust the policy rate (by appropriately adjusting the nominal rate, i). Suppose the expected inflation in any period is given by the previous period's actual inflation. Calculate the lowest real rate of interest (the policy rate) that the Fed can attain in period 1. Calculate the resulting level of GDP and the rate of inflation. (C) Again, suppose the expected inflation in any period is given by the previous period's actual inflation. Calculate the real rate of interest (the policy rate), the level of GDP and the rate of inflation that the Fed can attain in period 2. (D) In view of your answers to parts (B) and (C) is there any evidence that the economy is in a deflation trap due to ZLB? Explain using a suitable IS-LM-PC graph. (E) Suppose instead of the previous period's actual inflation rate, expected inflation is anchored at 2%. In other words, tº = = 2%. Repeat your calculations for parts (B) and (C). Is there any evidence of deflation trap now? Explain. (No new graph is needed.)
