1. The Fed sets the fed funds rate. What interest rates does investment depend upon? Explain how the fed funds rate is related to those interest rates (some algebra will

be helpful). 1. The economy begins in the short-run steady state. There is a cost shock at date I equal to o > 0(for example, an oil price shock). a) Using equations and words, explain how output and inflation respond to this shock under the basic monetary policy rule. How does the economy adjust over time? What did you assume aboutexpectations? b) Write out and briefly interpret a Taylor rule. If the Fed uses the Taylor rule, use your equations and words to show how output and inflation respond to the cost shock. Explain how it changes the adjustment towards the steady state.

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