(a)Draw a figure, using the Keynesian IS-LM framework, of an economy in recession.(b)Now suppose the IS curve shifts up and to the right far enough that if the real interest rate is unchanged, output will increase beyond full employment. If the Fed's goal is to move output to its full-employment level, what must happen to the real interest rate? What is the effect on the price level? (c)Suppose, before the Fed can act, that the government announces a restrictive fiscal policy, shifting the IS curve down and to the left relative to its position in part (b) What is the Fed likely to do (relative to what it would do if fiscal policy wasn't restrictive) if its goal is to target full-employment output? What happens to the real interest rate relative to what it is in part (b)?
What will be an ideal response?
| (a) | The figure should be drawn such that the IS and LM curves intersect to the left of the FE line. |
| (b) | The Fed would shift the LM curve to restore general equilibrium. The real interest rate would |
| (c) | Tighter fiscal policy means the Fed shifts the LM curve down and to the right relative to what it |
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