University of Massachusetts D

Keep in mind
that the process of how you arrive at an answer is as important as the answer itself. Therefore,
full credit will require you to show all steps and work; clearly label any graphs; and fully explain
any answers that ask for an explanation.
You can either type your answers using a word processing software of your choice (but be sure
to still show all steps and work!) or write them by hand and scan them using the camera on your
phone/tablet. In either case, you need to submit the file as a single pdf document.

Question 1: Fiscal policy in the IS-LM-PC model

a. Set up an IS-LM-PC graph for an economy at potential output and inflationary expectations
are adaptive.

b. Now assume there is a decrease in government spending in period t. Show the effect of this
decrease in G on your graph in (a). [Clearly label which part of your graph refers to b)].

c. In period t+2 the central bank reacts. Show the central bank’s policy response on your graph,
and explain. [Again, be sure to clearly label what part of your answer refers to part (c)].

Question 2: Demand shocks and monetary policy.

For this question begin by setting up the IS-LM-PC model to describe an economy in mediumrun equilibrium (i.e. Y=Yn and inflation is at the inflation target).

a. There are tax cuts in period t, and the central bank does not change the real policy rate. Show
the effect of these tax cuts on the short-run equilibrium in an IS-LM-PC diagram.

b. Assume that inflationary expectations are adaptive. If the central bank leaves the policy rate
unchanged, what happens to inflation in period t+1? If the central bank still doesn’t react,
what happens to inflation in period t+2?

c. Now assume that inflationary expectations are anchored. If the central bank leaves the policy
rate unchanged, what happens to inflation in period t+1? If the central bank still doesn’t
react, what happens to inflation in period t+2?

d. Suppose that in period t+3, the central bank changes the policy rate to bring the economy to
potential output and back to 2% inflation.
i. Does the central bank increase or decrease the policy rate?
ii. How will the central bank policy differ in (b) and (c)? Why?

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