Suppose the Target Rate of Inflation Is 3 Percent and Real

Essay

Suppose the target rate of inflation is 3 percent and real GDP equals potential GDP.Now,suppose a major oil-producing country decides to increase the supply of oil in order to discipline the other members of the oil-producing cartel.There is a sharp decline in the price of oil,and,in turn,the rate of inflation falls to 2 percent in the short run.The Fed views this decline in inflation as temporary and expects the price adjustment line to shift back up to 3 percent next year,which it does.
(A)Where will real GDP be in the short run? If the Fed follows its usual policy rule,how will the economy adjust back to potential?
(B)Now,suppose the Fed is sure this is a temporary decline in the inflation rate.Therefore,it decides not to follow its typical policy rule,but instead maintains the interest rate at the level it was at prior to the shock.What happens to real GDP? Why? What will the long-run adjustment be in this case?