Part A:

1. Suppose the economy has a positive unemployment gap. Then:

2. Suppose the economy is initially in general equilibrium and is at its target inflation when it experiences a temporary negative supply shock. In response, the inflation-targeting central bank reacts to keep inflation at its original, pre-shock level. Then:

3. When property rights are well defined and inexpensive to enforce:

4. Prudential regulation:

5. If monetary policy is used for short-run stabilization purposes, then long-run economic growth will be slower the ________ is fiscal policy and thus the ________ is the real policy interest rate.

6. The actual government budget deficit ________ be used to determine the effectiveness of discretionary fiscal policy actions because ________.

7. With flexible exchange rates the fiscal policy multiplier becomes:

8. Suppose that U.S. monetary and fiscal policies remain unchanged while the European Union adopts an expansionary fiscal policy and a contractionary monetary policy. With ________ European real interest rates, the resulting ________ of the U.S. dollar will eventually ________ U.S. net exports.

9. An increase in the credibility of monetary policy is represented by a change in:

10. Consider two identical economies hit by the same temporary negative aggregate supply shock. In the economy with the more credible monetary policy, there will be:

Part B:

Answer BOTH of the following questions based on the standard models of analysis developed in class. The information in the various parts of the questions is sequential and cumulative. Be sure to show and discuss each individual effect and not just the net effect of any exogenous shocks.

1. The AD/AS Model with Supply-Side Economic Effects. Suppose the economy is characterized by (1) sticky wages and prices and (2) substantial supply-side economic effects. The economy initially (i.e., in Year 0) has a cyclical budget deficit.

a. Based only on this information, use an AD/AS model diagram to clearly and accurately show the economy's initial (1) economic output and (2) inflation. This diagram should be drawn in BLACK.

b. In Year 1, the government enacts (1) a significant permanent increase in marginal personal income tax rates and (2) a sharp permanent decline in government consumption purchases. In response, the central bank engages in a discretionary monetary policy easing of 2 percentage points, sufficient to offset the aggregate demand effects of the change in government purchases. Meanwhile, the financial markets increase the term premium by 2 percentage points. Incorporating only this new information, clearly and accurately show on your diagram above what, if anything, happens to (1) economic output and (2) inflation. These effects should be drawn in RED

c. Provide an economic explanation of what you have shown in your diagram above. Discuss what, if anything, happens to (1) economic output and (2) inflation. Be sure to explain why these changes take place and what causes them.

d. In Year 2, the increase in the term premium that occurred in Year 1 is completely reversed. Incorporating only this additional information, clearly and accurately show in your diagram above what, if anything, happens to (1) economic output and (2) inflation. These effects should be drawn in BLUE.

e. Provide an economic explanation of what you have shown in your diagram above. Discuss what, if anything, happens to (1) economic output and (2) inflation. Be sure to explain why these changes take place and what causes them.

2. The AD/AS Model with a Foreign Exchange Market (35 points). Suppose the economy, which is characterized by sticky wages and prices, perfect capital mobility, and a flexible exchange rate with a direct quote, is initially (i.e., Year 0) in general equilibrium.

a. Based only on this information use an AD/AS diagram (on the left) and a Foreign Exchange Market diagram (on the right) to clearly and accurately show the economy's initial (1) economic output, (2) inflation, and (3) exchange rate. These diagrams should be drawn in BLACK.

b. In Year 1 the central bank engages in an open market purchase of government securities. Incorporating only this additional information, clearly and accurately show in your diagrams above what, if anything, happens to (1) economic output, (2) inflation, and (3) the exchange rate. These effects should be drawn in RED.

c. Provide an economic explanation of what you have shown in your diagrams above. Discuss what, if anything, happens to (1) economic output, (2) inflation, and (3) the exchange rate. Be sure to explain why these changes take place and what causes them.

d. Subsequent to the monetary policy change but still in Year 1, the government decides to peg the exchange rate at its initial (i.e., Year 0) level. Incorporating only this additional information, clearly and accurately show in your diagrams above what, if anything, happens to (1) economic output, (2) inflation, and (3) the exchange rate. These effects should be drawn in BLUE

e. Provide an economic explanation of what you have shown in your diagrams above. Discuss what, if anything, happens to (1) economic output, (2) inflation, and (3) the exchange rate. Be sure to explain why these changes take place and what causes them. Also, be sure to explain exactly what the central bank must do in order to peg the exchange rate.