Monetary Offset and the Effects of a Fiscal Stimulus. This problem helps you think about how and when a fiscal stimulus can be helpful in getting the economy out of a recession. Note: for this entire question, let's ignore any movements in inflation (one way to think about this is that all of these changes take place at the same time, before inflation adjusts).

(a) Imagine the economy starts at potential, in point A in Figure 1 on the next page. A negative shock reduces demand by 1 trillion dollars (a = -1T). This shifts the IS curve to the left, and the economy goes to point X. Suppose the Fed is following the Taylor Rule for setting interest rates. What does it do? Because of "long and variable lags" of monetary policy, assume the economy only moves half-way back to potential. Draw this response in the IS-MP diagram and call the new location of the economy point B.

(b) Now imagine the government observes the economy at point B and thinks "Output is [let's say] 1/2T below potential, so we should do 1/2T worth of fiscal stimulus." Show in a graph which curve shifts, and what the impact on the economy is. What would happen to short-run output if the Fed kept interest rates unchanged? Label this point Y in your graph.

(c) Notice, however, that SR output is rising between points B and Y. If the Fed is following a Taylor Rule, what does it do to interest rates, and what is the effect on the economy?

(d) In a few sentences, discuss the general point of this problem.