Answer all questions in Section C. (only for question 2)
question 1. Consider the closed-economy model of chapter 11.
(a) Suppose the economy is initially in long-run equilibrium with Y = Y¯ , r = ¯r, and P = P1. Draw IS-LM and AD-AS diagrams showing this equilibrium.
(b) Suppose the economy is then hit by an adverse supply shock, which causes P1 to jump up to P2 > P1. Using Keynesian cross and money market diagrams, explain what will happen to the IS and LM curves in the short run as a result of this shock.
(c) Use IS-LM and AD-AS diagrams to show what happens to the economy in the short-run, long-run, and during the transition, following the supply shock from part (b). Explain in words what is happening.
(d)Suppose the central bank wishes to achieve output stability; that is, suppose the central bank would like to keep Y from ever changing. In response to the change in P in part (b), what, if anything, can the central bank do to achieve this goal? How would the long-run equilibrium levels of Y , P and r in this case compare to the one where the central bank does nothing?
question 2. (33 marks total) Re-do question #1, but assuming we are in the small open economy MundellFleming model, instead of the closed economy IS-LM model. In particular, suppose the economy is initially in long-run equilibrium with Y = Y¯ , P = P1, and = ¯. Assuming the central bank is running a floating exchange rate regime, answer parts (a)-(d) from #1, but with the following modifications:
a)• Use the IS∗ and LM∗ curves in place of the IS and LM ones. (NOTE: As at the end of chapter 12, use the RER on the vertical axis of your IS∗ -LM∗ diagrams, not the NER.)
b)• For part (d), instead of supposing the bank would like to keep Y from changing, suppose it wants to keep from changing
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