Question 2

Show both versions of the liquidity trap below. On the left side, show how the liquidity-trap can be depicted using the monetary-market model.On the right side, show how the liquidity-trap can be depicted using the AE/PC model (label the target real interest rate with a suffix 'T'. In both cases you can assume the Central Bank is responding to an adverse expenditure shock from the long-run equilibrium and target inflation using countercyclical monetary policy. Label the axes, mark the curves and all points of interest (using methods as outlined in the previous questions). Answer the additional questions below. For simplicity assume no lags.

Money MarketAE/PC