1. Suppose that due to a housing price bust (i.e. house prices unexpectedly fall), households' wealth falls (say, due to 'underwater' mortgages). This is an example of a negative wealth shock, which makes households' less willing to spend (i.e. consumption falls, ceteris paribus). Use this information to answer parts a, b of this question.

a. Use the standard IS-LM framework to analyze the effect of the shock mentioned above on the equilibrium interest rate and the equilibrium income. Clearly label the graph, carefully marking the initial equilibrium and the short run equilibrium after the shock. Explain the intuition as of why and how the equilibrium interest rate changes.

b. Now suppose that the government wants to mitigate the short run negative effects of this shock. With the help of the IS-LM model analyze policies (fiscal and monetary) that the government and the Fed can pursue in the short run to bring the economy's output back to its initial (pre-shock) level.

You can analyze each policy on a separate graph and assume that the policy is powerful enough to bring the economy's output to its initial equilibrium level on its own. Starting from the after-shock equilibrium point, show how each policy brings the economy's output back to its pre-shock level. Explain in words (that is, provide intuition of) how and why equilibrium output and interest rate change in response to each policy. Clearly label the graphs

c. Suppose now that in addition to the negative wealth effect described in (1), the housing bust triggers severe disruptions in financial intermediation due to financial panics as seen during the Great Recession. That is, the supply of credit to firms, who rely on bank credit for financing there investment projects, significantly falls. Suppose that the combined fall in aggregate demand (consumption + investment) is so large that it pushes the economy into Liquidity Trap (that is, nominal interest rates hit Zero Lower Bound, ZLB).

Use the modified IS-LM framework that incorporates ZLB to show the effects of the shock on income (output) and interest rates. On a separate diagram, show the effect of this same shock of the same magnitude on income (output) when the ZLB does not bind. How does this effect compare with the one under the binding ZLB? Use the graphs for illustration.

d. Now suppose that the government wants to mitigate the short run negative effects of this combined large shock which pushes the economy in liquidity trap. That is, the after-shock short-run equilibrium is now on the flat part of LM curve. With the help of the modified IS-LM model (with ZLB) analyze monetary and fiscal policies. Which policy is more effective at bringing the economy's output back to its initial (pre-shock) equilibrium? You can analyze each policy on a separate graph. Starting from the aftershock equilibrium point, show how each policy can affect the economy's output and which policy is more effective at doing so. Explain in words (that is, provide intuition of) how and why equilibrium output and interest rate change in response to each policy. Clearly label the graphs.

e. Now suppose that the Federal Reserve can credibly commit to any future inflation target. Describe the policy (i.e. a level of targeted inflation) that the Fed should pursue to get the economy out of the liquidity trap. Use the graph to illustrate your answer.