1. For each of the following scenarios, use the Fed model to forecast how output, the real interest rate, and inflation will change. In each case, start with an economy with an output gap of zero, and with no unexpected inflation, and illustrate how economic conditions will change.

a) A breakthrough in solar power technology decreases the price of energy.

b) The election of a new president leads households to become more hopeful about their future economic prospects, which leads them to increase their consumption.

c) In response to concerns about rising national debt, the federal government passes a new bill that dramatically reduces government spending on education and the military.

d) In a shock to financial markets, the Federal Reserve announces that it will decrease the federal funds rate from 3% to 1.5%.

2. For each of the following, diagnose whether it is a financial, spending, or supply shock that has hit the economy.

a) On your drive to campus you hear a radio report describing how the recession appears to have ended and while output remains less than potential, the output gap has risen from -7% to -5%. The host is interviewing an economist who states, "The change in GDP isn't terribly surprising, as the Federal Reserve continues to cut the real interest rate."

b) The latest inflation report indicates an unexpected uptick in inflation even though output remains below potential output.

c) The real interest rate has been stable over the past few quarters, yet output has grown rapidly, leading to a more positive output gap.