Assume that the economy is in equilibrium, but that equilibrium is associated with the actual level of output in the economy, well below the natural level of output.

(i)Describe the action that would be undertaken by the government to move the economy to the natural level of output.

(ii)Using the IS-LM model, illustrate the impact of the policy (from part i above). Clearly identify the new equilibrium position on your diagram.

(iii)Discuss in detail the costs of implementing the policy undertaken in part (i) above.

(iv)If the central bank decides not to accommodate the policy undertake in part (i) above because it considers that the policy will breaches its inflation target, what action will it undertake? Illustrate how this action will now impact the economy using the IS-LM model - include in the diagram both the initial government action undertaken, labelling the equilibrium as point A as well as the central bank policy outcome, labelling it as point B.

(v)Explain why a relatively flat IS curve and a relatively steep LM curve will reduce the effectiveness of the fiscal policy implemented above.

(b)Discuss the problem of adhering to the "Taylor" rule targeting inflation if severe supply shocks occur in an economy.