Following a period of stable inflation equal to its target value and output equal to potential, the country of Utopia is hit with an expansionary AD shock.
(i) Using the AD-AS model — with positively sloped AS curve and adaptive expectations — explain the short-run and long-run effects of the AD shock if it is temporary (i.e. lasts for one-period). (5 marks)
The central bank of Utopia uses the following rule for setting the value of its nominal policy interest rate.