Economics 134
Professor Christina Romer
Spring 2012
Professor David Romer
PROBLEM SET 2
D
UE AT THE
B
EGINNING OF
L
ECTURE
,
F
EBRUARY
28
You may work together on the problems, but you should try each question yourself and the
answers must be written up in your own words. For all questions be sure to explain your
answers carefully and to use graphs whenever appropriate.
1. Use the ISMPIA model to determine the shortrun and longrun effects of a tax cut on
output, inflation, the real interest rate, consumption, and investment. Assume that initially
the economy is in longrun equilibrium and that it is not constrained by the zero lower
bound.
2. This problem asks you to examine the effects of fiscal austerity in the IS–MP model.
Specifically, suppose that there are two simultaneous developments. First, government
purchases are reduced. Second, the Federal Reserve changes its interest rate rule so that its
desired real interest rate for a given level of output and inflation is lower than before.
Describe whether the combined effect of these two developments will be to raise,
lower, or have no effect (or whether it is not possible to determine the effect) on output and
the real interest rate in the short run if:
a.
Monetary policy is not constrained by the zero lower bound on the nominal interest
rate.
b.
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 Spring '12
 DavidRomer
 Economics, Inflation, Monetary Policy, natural rate, potential output

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