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Question 2. Begin in a medium-run equilibrium where actual and expected inflation equals 2% in period 0 and suppose there is an increase in consumer confidence, e.g. due to a stock market boom, in period 1. Parts (a), (b) and (c) below assume adaptive expectations, i.e. $\pi^e_t = \pi_{t-1}$ (expected inflation in each period equals lagged inflation from the previous period). a. How does the IS curve change from period 0 to period 1? What is the value of expected inflation in period 0? How does the short-run equilibrium output and inflation rate in period 1 compare to the equilibrium output and inflation rate in period 0 if the central bank does not change the real policy rate from period to period 1? b. Now advance the economy to the period 2 equilibrium under the assumption that consumer confidence remains high. If the central bank leaves the real policy rate unchanged will inflation be higher or lower in period 2 than in period 1? c. What do you conclude about the central bank policy of keeping the real policy rate unchanged in period 2? Is it sustainable?

          Question 2. Begin in a medium-run equilibrium where actual and expected inflation equals
2% in period 0 and suppose there is an increase in consumer confidence, e.g. due to a stock
market boom, in period 1. Parts (a), (b) and (c) below assume adaptive expectations, i.e.
$\pi^e_t = \pi_{t-1}$ (expected inflation in each period equals lagged inflation from the previous
period).
a. How does the IS curve change from period 0 to period 1? What is the value of
expected inflation in period 0? How does the short-run equilibrium output and
inflation rate in period 1 compare to the equilibrium output and inflation rate in
period 0 if the central bank does not change the real policy rate from period to
period 1?
b. Now advance the economy to the period 2 equilibrium under the assumption that
consumer confidence remains high. If the central bank leaves the real policy rate
unchanged will inflation be higher or lower in period 2 than in period 1?
c. What do you conclude about the central bank policy of keeping the real policy rate
unchanged in period 2? Is it sustainable?

Question 2. Begin in a medium-run equilibrium where actual and expected inflation equals
2% in period 0 and suppose there is an increase in consumer confidence, e.g. due to a stock
market boom, in period 1. Parts (a), (b) and (c) below assume adaptive expectations, i.e.
π^et = πt-1 (expected inflation in each period equals lagged inflation from the previous
period).
a. How does the IS curve change from period 0 to period 1? What is the value of
expected inflation in period 0? How does the short-run equilibrium output and
inflation rate in period 1 compare to the equilibrium output and inflation rate in
period 0 if the central bank does not change the real policy rate from period to
period 1?
b. Now advance the economy to the period 2 equilibrium under the assumption that
consumer confidence remains high. If the central bank leaves the real policy rate
unchanged will inflation be higher or lower in period 2 than in period 1?
c. What do you conclude about the central bank policy of keeping the real policy rate
unchanged in period 2? Is it sustainable?

Added by Guillermo N.

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