ESSAY QUESTION

An economy suffers a sudden and severe reduction in expenditures. Under the assumption that the zero lower bound does NOT constrain, discuss what is the likely appropriate policy response that the central bank should pursue. Exactly what should the central bank do? Is such a response consistent with its Taylor Rule? Why? Is it consistent with the Fed's 'dual mandate?' Why? Discuss briefly also the channels of transmission: what will be the expected impact of this policy? How would the policy be expected to counter the impact of the expenditure shock?