Exhibit 25-3 -Suppose the Target Rate of Inflation Is 3 Percent and
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question 37

Essay

Exhibit 25-3 $$\begin{array} { | c | c | } \hline \begin{array} { c } \text { Inflation } \\\text { (percent) }\end{array} & \begin{array} { c } \text { Real GDP } \\\text { (billions of } \\\text { dollars) }\end{array} \\\hline 4.5 & 6,700 \\\hline 3.5 & 6,800 \\\hline 2.5 & 6,900 \\\hline 1.5 & 7,000 \\\hline 5 & 7,100 \\\hline\end{array}$$
-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 wril real GDP be in the shart run? If the Fed follows its usual palicy rue, haw will the economy adjust back to potential?
(B) Naw, suppose the Fedi is sure this is a temporary decline in the intlation rate. Therefare, it Aecides not to follow its typical policy rule, but instead maintans the interest rate at the level it was at prior to the shock. What happens ta real GDp? Why? What will the lang-run adyustment be in this ca5e?

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Definitions:

Standard Deviation

A measure of the amount of variation or dispersion of a set of values.

Sampling Distribution

The probability distribution of a given statistic based on a random sample, used in hypothesis testing and estimation.

Large-Sample Significance

Refers to the level of significance or inferential reliability obtained when testing hypotheses with a large sample size, typically leading to more precise estimates.

Z Statistic

A type of standard score that indicates how many standard deviations an element is from the mean of the population.