Suppose the central bank instead of following the rule r = r(Y,pi), has a target level of inflation. Specifically, it sets r according to r = r^LR + b[pi - pi*]. Here r^LR is the real interest rate when the economy is in long-run equilibrium; that is, it is the real interest rate that causes the loan market to be in equilibrium when Y=Y bar. In addition, pi* is the central bank's target level of inflation , and b is some positive parameter. This rule states that the central bank raises the real interest rate above its long-run level when inflation is above its target and lower when it is below its long-run level when inflation si below its target.

a. With this monetary policy, is the MP Curve upward sloping, flat or downward sloping? Explain.

b. Is the AD curve upward-sloping,flat or downward-sloping? On the AD curve, what level of Y is associated with pi = pi*? Explain

c. Suppose some development raises r^LR, but does not change Y bar. How, if at all, does this affect the AD curve?

d. Assume the economy starts in a situation where pi = pi* and Y = Y bar. Describe the immediate effects of a government purchase has on each of the following (output, inflation and real interest rate).