Consider an economy described by the following equations: LRAS curve: = 7 AS curve: = IS curve: = 6 0.5 where output is measured in trillions of dollars. The MP curve is = 9 + as long as the nominal interest rate is > 0 (i.e. not at the zero lower bound).

i) Suppose that inflation expectations are adaptive, meaning that inflation expectations take the value of current inflation = . Then, according to the Fisher equation, if nominal interest rates cannot be negative then the real interest rate must satisfy:

a)

b)

c)

d)

ii) At which level of inflation is the central bank no longer able to follow the Taylor principle? (i.e. at which level of inflation does the MP curve have a "kink"?)

a) = 4.5

b) = 0

c) = 4.5

d) there is not enough information

iii) Which of the following equations describes the demand curve in "normal" times?

a) = 6 0.5

b) = 10.5 0.5

c) = 6 0.5

d) = 10.5 0.5

iv) In equilibrium, what are the levels of output and inflation?

a) = 7, = 7

b) = 7, = 4

c) = 4, = 7

d) = 4, = 4

v) Is the economy at the zero lower bound?

a) yes

b) no

c) there is not enough information

Suppose now that there is a crisis in the housing market that increases the credit spreads of mortgages substantially. This increase in credit spreads causes the IS curve to shift to the left. It is now described by IS2: = 2 0.5. vi) Which of the following equations describes the new demand curve in "normal" times? a) = 2 0.5

b) = 6.5 0.5

c) = 2 0.5

d) = 6.5 0.5

vii)At which level of output does the new aggregate demand curve have a "kink"? (hint: use your answers to questions ii and vi above)

a) = 3.75

b) = 4.25

c) = 0.25

d) = 0.75

viii) In equilibrium, what are the levels of output and inflation?

a) = 4, = 4

b) = 1, = 1

c) = 4.33, = 4.33

d) = 1.33, = 1.33