Question 1:
An oil price shock (hard): Suppose the economy is hit by an
unexpected oil price shock that permanently raises oil prices by $50 per barrel. This
is a temporary increase in o in the model: the shock o becomes positive for one period
and then goes back to zero.
a). This is a temporary increase in ¯o in the model: the shock ¯o becomes positive for one
period and then goes back to zero. Explain why this is correct.
(b) Using the full short- run model, explain what happens to the economy in the absence
of any monetary policy action. Be sure to include graphs showing how output and
inflation respond over time.
(c) Suppose you are in charge of the central bank. What monetary policy action would you
take and why? Using the short- run model, explain what would happen to the economy in this case. Compare your graphs of output and inflation with those from part (b).


Question 2: Private versus public investment (a FRED question): Consider an economy that begins with output at its potential level and a relatively high
inflation rate of 6As the head of the Federal Reserve, your job is to pick a sequence of
short- run output levels that will get the rate of inflation back down to 33 years from
now. Your expert staff offers you the following menu of policy choices:
(a) According to these numbers, what is the slope of the Phillips curve?
(b) you as a policymaker cared primarily about output and not much about the inflation rate, which option would you recommend? Why?
(c) If you cared primarily about inflation and not much about output, which option would you recommend? Why?
(d) Explain the general trade- off that policymakers are faced with according to the Phillips curve.