Assume that b=1/2 and that initially the real interest rate is equal to the marginal product of capital at 3%. As well, assume that v=2 and that the inflation rate last period was 2%. Assume the natural rate of unemployment is 5.5%.

a. The Sequester is probably a bad idea. Use the IS-MP model to explain what should happen to the economy if the government cuts spending by 1 percentage point of potential GDP.

b. How much can we expect this to increase the unemployment rate?

c. How much will this change inflation? What will the inflation rate be in the period of the cuts?

d. What was the nominal interest rate last period (before the cuts) if the real rate was equal to the marginal product of capital?

e. What happens to the real rate of interest this period (after the cuts) if the Federal Reserve does nothing to change the nominal rate? What will this do to the economy? Remember that the government has cut spending in question 2a.

f. What does the Federal Reserve have to change the nominal interest rate to in order to close the output gap?