1. Assume that for this question b=2 and v=4. Suppose that the natural rate of unemployment is 5% and inflation when the economy is at potential is 0%. Assume that marginal product of capital is 3%.

• What is the nominal rate of interest when the economy is at potential?
• Show what happens to the economy if, due to fears of a coming recession, banks demand an extra 2% risk premium on any lending.
• What is inflation and unemployment?
• If the Fed does not change the nominal rate what will the real risk free rate be after the increase in the risk premium? Treat this like it is happening at the beginning of period t+1.
• How low can the Fed lower the real rate after the change in the risk premium at time t+1? What will this do to the economy?
• What will the government have to do to bring the economy back to potential?