Consider the AS-AD model discussed in Lecture 5. The AD curve is given by: Yt = (t ), (4) where Yt is short-run output, t is current inflation and is an inflation target pursued by the central bank. The AS curve can be written: t = t1 + Yt + . (5) a. Explain where the two equations come from and explain the intuition behind them. b. How would you interpret and ? Which values must they assume in a steady-state, i.e. in the long run. c. Analyse the effect of making the inflation target more ambitious, i.e. the effect of lowering . Illustrate your answer in a diagram and explain the intuition. d. Suppose that the demand for domestic goods decreases abroad, so that the export share of potential output temporarily decreases. Analyse the effects on inflation and short-run output using a diagram..

1. Consider the AS-AD model discussed in Lecture 5. The AD curve is given by:
Yt = (t ), (4)
where Yt is short-run output, t is current inflation and is an inflation target pursued by the
central bank. The AS curve can be written:
t = t1 + Yt + . (5)
a. Explain where the two equations come from and explain the intuition behind them.
b. How would you interpret and ? Which values must they assume in a steady-state, i.e.
in the long run.
c. Analyse the effect of making the inflation target more ambitious, i.e. the effect of lowering
. Illustrate your answer in a diagram and explain the intuition.
d. Suppose that the demand for domestic goods decreases abroad, so that the export share
of potential output temporarily decreases. Analyse the effects on inflation and short-run
output using a diagram.