Assume a hypothetical economy is currently operating at its potential level of GDP, with a zero output- gap. Also assume that this economy is currently running a large budget deficit.

1. Depict this situation in an IS-LM diagram where the former is downward sloping and the latter horizontal. Label your diagram carefully. (3 marks)

2. Now suppose the government decides to reduce its budget deficit. Discuss the type of fiscal initiatives this government should take to achieve this goal. Show the impact of your recommendations in this diagram and discuss what happens to real GDP and C. Label the new equilibrium point. (7 marks) ) What is the central bank money (Monetary base)?

Should this country's central bank take any action in light of the development in part (b) assuming that its objective is maintaining potential GDP? If so, what action? Show this in your diagram and label the new equilibrium point