Suppose the Fed is concerned that deflation would harm the economy over the long run. Use the IS-MP model (including the output gap Phillips curve in all your graphs) to analyze how the Federal Reserve would fight deflation.
a. Use an IS-MP model graph to show long-run macroeconomic equilibrium with a deflation rate of 2%.
b. If the Fed wants the economy to return to a long-run equilibrium with an inflation rate of 2%, how should it change its target for the federal funds rate? Use an IS-MP model graph to show the effects of this change in the target for the federal funds rate. What happens to the output gap and to the actual inflation rate?
c. Use an IS-MP model graph to illustrate and explain how the economy returns to long-run equilibrium at the higher inflation rate.