Question 4 (25 marks) Assume that aggregate demand in the economy is given by

Yd=C+I+G (1) C = C + mpc(Y T ) (2)

I = I-d(r + f) (3)

G = G (4) Assume there is no external sector in the economy.

(a) Derive and plot IS curve. Explain clearly the interpretation of the IS curve. What is it capturing? [5 marks]

(b) Assume that the monetary policy rule in this model is simplified to r = r , hence no inflation is present in the model, and the interest rate is set exogenously by the central bank. Derive the equilibrium of the model and show it graphically. [5 marks]

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(c) Explain how the IS curve shifts in response to a decrease in taxes, i.e. a decrease in T . If T decreases by 1, will the IS curve shift by 1, by more than 1 or by less than 1? Assume that government spending remains the same. [5 marks]

(d) Suppose the government decreases taxes, while keeping government spending unchanged. Can the central bank in principle change the stance of monetary policy to avoid that the change in taxes affects the equilibrium level of output? Discuss how any component of aggregate demand changes. Can you think of a reason why the central bank executes this monetary contraction? [5 marks]

The above model economy does not feature inflation nor inflation expectations, and does not feature a Phillips curve.

(e) Explain what the Phillips curve is and the difference between the short run and the long run Phillips Curve. [5 marks]