An economy is humming along very nicely in full long run equilibrium. All real variables are at their natural rates. Actual and expected inflation are both equal to the 2% inflation target. As the years go by, the price level goes: 90, 92, 94, 96, 98, and everybody expects it to continue 100, 102, 104, forever and ever.
Then a negative Aggregate Demand shock hits, and the central bank is slow to respond. Instead of going to 100, as everyone had expected, the price level in year 0 is 99. What else happens?
There's a recession. Real output and employment fall below their natural rates, and unemployment rises above its natural rate. But the story doesn't end there.
1. Now suppose that the central bank wakes up, announces that it will make sure the price level rises at 2% per year from now on, and everybody fully expects the central bank will do what it says, and the price level does in fact go: 99, 101, 103, 105, etc.
Question 1: in year 1, when the price level is 101, and the actual and and expected and target rates of inflation are all equal, will this economy still be in recession, or will it have completely recovered to the natural rates of output, employment, and unemployment?
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