2. IS/MP/IA Model Assume the economy behaves according to the assumptions in the IS/MP/IA model. Assume the economy begins at full employment.

2.1. Using the space below, illustrate IS/MP (top panel) and AD/IA diagrams (bottom panel) below. Be sure to carefully label the axes, curves, and initial equilibrium Point A. You must label the axes using words and symbols. Label equilibrium values and full employment on your diagrams. [4]

2.2. Suppose there is an increase in business confidence. Which exogenous variable in the model is changing? Use the notation from class and state in words. [1]

2.3. Illustrate the short-run effects of the change mentioned in #2 on your diagrams above. Clearly label any new curve and equilibrium values. Label the new short run-equilibrium Point B. [4]

2.4. Based on your diagrams, how do the following variables change in the short run (Point A to Point B): [2.5]

x Real interest rate Increase Decrease No Change

x Output Increase Decrease No Change

x Consumption Increase Decrease No Change

x Investment Increase Decrease No Change

x Inflation Increase Decrease No Change

2.5.Based on one of the two theories of incomplete price adjustment (theories of aggregate supply), explain why the economy transitions from A to B in the short run. State the name of the theory, key assumptions, and explain why the economy adjusts from A to B instead of directly to full employment in the short run. [4]

2.6.Illustrate the economy's long-run equilibrium on your figures from #1. Clearly label any new curve and equilibrium values. Label the new long run-equilibrium Point C. [4]

2.7.Based on your diagrams, how do the following variables change in the short run (Point A to Point C): [2.5]

x Real interest rate Increase Decrease No Change

x Output Increase Decrease No Change

x Consumption Increase Decrease No Change

x Investment Increase Decrease No Change

x Inflation Increase Decrease No Change

2.8.Suppose you are serving as a policy advisor to the Fed Chairman and the economy is currently at Point B on your diagrams above. If the Federal Reserve pursues an active stabilization policy, what is the appropriate response in this case? Would this involve fiscal policy or monetary policy? What would be the benefit of this policy? What would be the drawback? Explain, and feel free to use the space below to use a diagram to support your written explanation. [5]