(1)

y=50 ; π ¿ =2 ; ϕ=0.6 ;θ π =1; θ y =0.4 ; ρ=2 ; α=1

Since in long term equilibrium, inflation is stable and there are no shocks which implies that
π t =π t−1, ε t=v t =0. It implies that in long run equilibrium, inflation equals to central bank
¿
inflation target rate which is π t =π =2 ; real output is at the natural output level which is
y t = y=50 ; the real interest rate is equal to its natural rate, which is r t =ρ=2. Therefore, we
can infer that i=ρ+ π =2+ 2=4.

(2)
The equation for DAD curve is:
αθ π 1
Y t =Y − ( π −π ¿ ) + ε
1+αθ Y t 1+ αθ Y t

Based on the given information we can get that:

1× 1 1 10 10
Y t =50−
1+1 ×0.3
( π t −2 ) +
1+1 ×0.3
ε t =50− ( π t −2 ) + ε t
13 13

Equation for DAS:

π t =π t−1 +ϕ ( Y t −Y ) +ν t

Plugging Y t into the DAS function we can get that:

( 10 10 13 6
)
π t =π t−1 +0.6 50− ( π t −2 ) + ε t−50 = π t −1+ ε t +
13 13 19 19
12
19
'
( ν t=0 ; since∈long run equilibrium ther e s no supply shock ¿

The economy was experienced an adverse aggregate demand shock from t 1 ¿ t 4 and reverted
to 0 at t 5, which suggests that ε t=−2 ( t=1,2,3,4 ) and ε t=0 ( t=0,5,6,7,8, ... ) .

Thus, the inflation at t=1 is:

13 6 12 26
π t 1= π 0 + ε t 1 + = =1.3684 ;
19 19 19 19
The output at t1 is:
10 10
y 1=50− ( 1.3684−2 )+ × (−2 )=48.9474
13 13
Nominal interest rate t1:
i 1=1.3684+2+1 × ( 1.3684−2 ) +0.3 × ( 48.9474−50 )=2.421
Real interest rate at t1:
r 1=i 1−π 1=2.421−1.3684=1.0526

Therefore, we can clear that the demand side shock has impact on inflation that lower the
inflation by 0.6316; the demand shock decreases the output by 1.0526; demand shock
lowers the nominal interest rate by 1.579 and finally it lowers the real interest rate by
0.9474.
Overall, based on the results we got from above; we can observe that the demand shock has
less impact on inflation compared with the impact on output. Since θ π >θ y , which means
that the central bank focuses on inflation gap more than output gap, therefore, we can infer
the from t2 onward, the change in output will be more volatile than the change in inflation.

(3)
From (2) we had:
13 6 12
πt= π + ε+
19 t−1 19 t 19
10 10
y t = y− ( π t −2 ) + ε t
13 13
Excel output:
 12
Inflation
10

0
0 2 4 6 8 10 12

output
12

10

0
0 2 4 6 8 10 12

nominal interest rate

12

10

0
0 2 4 6 8 10 12
 12
real interest rate
10

0
0 2 4 6 8 10 12

From the diagrams above shows that inflation level starts to decrease from t1 and reach the
lowest inflation level (0.4383) at t4, then the inflation starts to converge back to the target
¿
inflation ( π =2¿ . The persistent adverse demand shock has effect on output that the output
decreases rapidly to 48.947 at t2 and increases to 50.8219 dramatically at t5, when the
shock is ended at t5, the output starts to decrease and return back to the initial level of
output y=50 at t31. Besides, both the nominal interest rate and real interest rate have the
same direction of change, they start to decrease when the shock occurred; when the shock
is finished, both nominal interest rate and real interest rate start to return back to the
natural level of interest rate.
¿
Given that ρ , Y , π , θ π , θY fixed, the demand shock has impact on monetary policy (
¿
i t =π t + ρ+θ π ( π t −π ) +θ Y ( Y t −Y )) that turns inflation gap and output gap to negative. Thus,
the central bank would lower the nominal interest rate in response to negative inflation and
output gaps. So we can see that the nominal interest rate keeps dropping from t1 to t4 and
starts to return back to the initial level from t5 onward.