1. A financial crisis: Suppose the economy starts with GDP at potential, the realinterest rate and the marginal product of capital both equal to 3 percent, anda stable inflation rate of 2 percent. A mild financial crisis hits that raises thefinancial friction from zero to 2 percent.

(a) Analyze the effect of this shock in an IS/MP diagram.

(b) What policy response would you recommend to the Federal Reserve?What would be the effect of this policy response on the economy?

(c) How would your answer to part (b) change if the financial crisis were verysevere, raising the financial friction to 6 percent?

(d) What other policy responses might be considered in this case?