Declia's economy is in short-run equilibrium with a recessionary gap of $100 billion and the marginal propensity to save is 0.5. The expected inflation rate is 12%, and the natural rate of unemployment is 10%.

(a) Based on the Phillips curve model, is the actual inflation rate greater than, less than, or equal to the

expected inflation rate of 12% in Declia? Explain.

(b) Assume the government takes no policy action with regard to the state of Declia's economy.

(i) What will happen to the actual rate of unemployment in the long run? Explain.

(ii) How will the long-run adjustment process be represented in the Phillips curve model? Explain.

(c) Assume that instead of waiting for the long-run adjustment, the government of Declia is considering

using fiscal policy to address the recessionary gap of $100 billion.

(i) If the government chooses to increase its deficit spending, calculate the minimum change in

government spending required to increase aggregate demand by the amount of the recessionary gap.

Show your work.

(ii) How will the effect of the government's action in part (c)(i) be represented in the Phillips curve

model? Explain.

(iii) If the government chooses to decrease income taxes instead of increasing its spending, calculate the

minimum change in income taxes required to increase aggregate demand by the amount of the

recessionary gap. Show your work.

(iv) Now suppose instead that the government wants to maintain a balanced budget and decreases both

government spending and income taxes by $75 billion. Will this policy make the output gap smaller,

make the output gap larger, or have no effect on the output gap? Explain.

(d) Suppose the government chose to implement only the policy described in part (c)(i). Based on

loanable funds market analysis, what will happen to each of the following?

(i) The price of previously issued bonds. Explain.

(ii) Capital stock. Explain.