Q1: Initial Equilibrium. Consider the IS-MP model. Draw the diagram corresponding to a situation where there are no AD shocks (normal-times AD) and the Fed sets the real interest rate equal to the MPK. Label the initial equilibrium as point A in the diagram. Which of the statements below is correct?

a. At the initial equilibrium (point A in the diagram), SRO will be equal to positive. In other words, actual output will be above potential output. In the labor market the unemployment rate will be lower than the NRU (natural rate of unemployment).

b. At the initial equilibrium (point A in the diagram), SRO will be equal to zero. In other words, actual output will be above potential output. In the labor market the unemployment rate will be equal to 0%.

c. At the initial equilibrium (point A in the diagram), SRO will be equal to zero. In other words, actual output will be equal to potential output. In the labor market the unemployment rate will be equal to the NRU (natural rate of unemployment).

d. At the initial equilibrium (point A in the diagram), SRO will be negative. In other words, actual output will be below potential output. In the labor market the unemployment rate will be above to the NRU (natural rate of unemployment).

Q2: Suppose the Fed announces that it is lowering the fed funds rate by 50 "basis points" (that is, by half a percentage point). Think about which curves need to shift in the IS-MP diagram. Update the diagram and label the new equilibrium as point B. Which of the statements below is correct?

a. The MP curve shifts down while the IS curve stays unchanged. As a result, we slide down the IS curve and point B will be at the intersection with the new MP curve. At point B, SRO will be positive. In other words, actual output will be above potential output and the unemployment rate will be lower than the NRU.

b. Both the MP curve and the IS curve shift down. As a result, at point B, SRO will be positive and the unemployment rate will be lower than the NRU.

c. The IS curve shifts up while the MP curve stays unchanged. As a result, the unemployment rate will be lower than the NRU.

d. The IS curve shifts down while the MP curve stays unchanged. As a result, we slide down the MP curve and point B will be at the intersection with the new IS curve.

Q3: Comparing the initial and final equilibrium points (A and B), which of the following statements is correct? It is helpful to review the equations for the IS curve and its components.

a. At point B, Investment will be higher than at point A because the real interest rate is now below the MPK. Consumption remains at the same level as in point B because potential income has not changed.

b. At point B, Investment will be the same as at point A because the MPK is unchanged.

c. At point B, Consumption will be higher than at point A because of the higher savings.

d. At point B, Consumption will be higher than at point A because the real interest rate is now below the MPK. Investment remains at the same level as in point B because potential income has not changed.