Suppose that the economy is well described by the IS-LM-AD-AS model with partially sticky prices studied in class. In your answers below, keep in mind the consumers' and firms' optimal decisions that give rise to the model and explain how and why agents' decisions change.

1. Suppose that the degree of price flexibility in the economy increases, such that the parameter in our price determination equation

Pt = P + (Yt Y f t )

changes. Explain how this change affects the effectiveness of fiscal policy. In particular, how do the responses of Y , P, N, r, and w, to a given shock in G, change when changes?