1. The Federal Reserve is concerned about a rapid increase in prices. Their decision is to stabilize prices through a decrease in money supply. Graphically illustrate and explain what effect a decrease in the money supply will have on the economy using the aggregate supply and aggregate demand model and the IS-LM model. In your graphs, clearly illustrate the short-run and medium-run equilibrium.

2. Taxes are affected by the level of economic activity: When output increases, tax revenues typically increase, when output falls, tax revenues fall. Suppose a balanced- budget amendment is passed by Congress, which requires that the budget always be balanced. Further assume that the economy is initially operating at its natural level of output and that the budget is currently balanced.

a. Now suppose consumer confidence declines. What effect will this have on the IS Curve (graph and explain), on the AD curve (graph and explain), output, tax revenues and on the budget?

b. Given that we now have a balanced- budget amendment, what will policymakers have to do in this situation?

c. Based on your answers in "a" and "b", what effect does the existence of a balanced-budget amendment have on the output effects of any shock to aggregate demand?

d. Based on your analysis in question "c", what happens to the fluctuations in output caused by shocks to aggregate demand in the presence of a balanced-budget amendment?

3. Using both the IS/LM and the AS/AD markets explain and graph what happens to a Budget Deficit reduction in the short and medium run.

Bt-1 = 3000 Gt= 350 Tt= 250 it = .10 πt = .05

a) Calculate the official measure of the deficit in year t.

b) Calculate the correct (i.e. inflation adjusted) measure of deficit in year t.

c) Calculate the primary deficit in year t.

d) Discuss what happens to the inflation adjusted deficit in year t if the nominal interest rate in year t increases to 17%.

e) To what extent does the official measure of the deficit overstate the correct measure?

f) Given the above information in "b", what will happen to the level of debt between years t-1 and t? Explain