3. You need both equations and clearly labeled graphs (separate graphs for each question) to answer the following questions. Assume that b=1/2 and that initially the real interest rate is equal to the marginal product of capital at 3%. As well, assume that v=2 and that the inflation rate last period was 2%. Assume the natural rate of unemployment is 5.5%.

a. The Sequester (a reduction in government spending) is probably a bad idea. Use the IS-MP model we developed in class to explain what should happen to the economy if the government cuts spending by 1 percentage point of potential GDP.

B. What does the Fed have to do to bring the economy back to potential? Show with an equation and a graph.