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My macroeconomic homework contains the question below, and I'm not sure what graphs we're suppose to use to solve it. I believe I can answer the whole question using the IS-MP Diagram, but do I need another? Is the AS/AD question just referring to the changes in demand for funds when the new interest rate is applied in the IS-MP Diagram?

  1. In the late 1990s and early 2000s, inflation was actually negative in Japan. I want you to consider a policy to achieve a higher inflation rate. Consider an economy that beings with output at potential and an inflation rate of 𝜋̅, so that the economy begins in steady state. A new chair of the central bank decides to raise the long-run inflation target to 𝜋̅2 (greater than the original 𝜋̅). Show how the economy responds over time using the AD/AS framework. Comment on your results.
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It seems that your teacher wants you to analyze the effects a higher inflation rate might have on the level of aggregate output based on whatever policy you might choose, i.e. drawing an AD/AS graph in long run equilibrium and demonstrating some shift as a result of the inflation-increasing policy.

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