Provide brief answers (each answer is typically no longer than four brief sentences) to the following questions. DON'T write long explanations.

1. Assume that the economy is at full employment. The government decides to cut taxes to give the economy an extra boost.

a. Using the IS-LM model, show the short run effect of this tax cut What will happen to output and the interest rate? (use graph) Note: this is NOT the only model to analyze the short-run impact of tax cut on GDP. The IS-LM model is a Keynesian model which focuses on the demand side of the economy. Alternatively, the supply side emphasizes the positive impact of a tax-cut on the economy as it can encourage more investments and thus increase employment and output.

b. What will happen in the long run?

c. If the Federal Reserve is following a policy of price stability, how should they react to the tax increase? If the Fed action is implemented, will the tax cut succeed in boosting output? Use a fully-labeled diagram and two or three brief sentences to explain your answers.

2. Suppose there is a huge discovery of oil reserve in the US that results in the drastic cut of oil prices.

DRAW A GRAPH HERE to answer part a, b, and c. (Label the graph)

a. What happens to the aggregate demand and supply curves in the US as a result of the shock above? (draw the effect in the above graph and write explanation below)

b. How will output and prices change in the short and long run? (draw the effect in the above graph and write the explanations of the adjustments that takes place in the economy below)

c. Faced with the favorable supply shock, if the Federal Reserve wants to stabilize output in the short-run, what should it do? What about the long-run? (draw the effect in the above graph and write explanation below)

d. No need to draw a graph: What's wrong if the Federal Reserve, wanting to neutralize the supply shock, decides to increase money supply?

3. Interaction between monetary & fiscal policy.

In the IS-LM model, monetary and fiscal policy variables are taken exogenously. While it is possible to examine the effect of each policy separately, there is a strong likelihood that the two policies are interacted which may alter the impact of the original policy change. For instance, monetary policymakers may adjust money supply in response to changes in fiscal policy, and vice versa. Now, suppose Congress increases government spending (fiscal policy). Indeed, as indicated by data, the US government spending has increased by 66% from the year of 2000 to 2008, more than doubled than the previous period. In response to the fiscal policy, the Federal Reserve can react with the followings:

a. hold money supply (M) constant
b. hold real interest rate (r) constant
c. decrease money supply (M)
d. increase money supply (M).

Using IS-LM model, analyze the effects of each of the fiscal and monetary policies above on interest rate and output. For each response, draw a graph and write a brief explanation (not more than four sentences). Use graph(s) and notations as given in class/textbook. Also, be neat in your works. Poor labeling (of graphs) can cost you significant points. WITHOUT explanations to support your graphs, you will get very minimal credit.

a. hold money supply (M) constant

b. hold real interest rate (r) constant

c. decrease money supply (M)

d. increase money supply (M).

e. Why the adverse effect on output is larger when the Fed is decreasing money supply than holding it constant? Explain.

4. The effectiveness of fiscal policy to stimulate or slowdown the economy depends on the responsiveness of demand for money to income (Y). Meanwhile, the effectiveness of monetary policy to stimulate or slowdown the economy depends on the responsiveness of investment to the interest rate.

a. Consider an increase in government spending in order to stimulate the economy. Using diagram, demonstrate that the extent to which the increase in government spending can affect the output/income and the interest rate depends on the responsiveness of demand for money to income.

b. Consider an increase in money supply in order to stimulate the economy. Using diagram, demonstrate that the extent to which the increase in the money supply can affect the output/income and the interest rate depends on the responsiveness of investment to the interest rate.