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?

2. (10 marks) Suppose that the economy is sitting at its frictionless long-run equilibrium (Yt = Y f t ). Suddenly, there is an international shock that decreases the average production cost in the economy (P decreases). Describe the new short-run equilibrium of the economy. In particular, explain the effect on the output gap, employment level, price level, interest rate, and real wage rate. How different would have been the macroeconomic effects of the shock absent the change in price flexibility ?

3. (10 marks) Given the reduction in P, the government decides to pursue an unexpected program of fiscal austerity in which Gt reduces significantly and Gt+1 is expected to gradually increase. Explain the rationale of this policy as a way to stabilise output around potential. Discuss the effects of this austerity policy on consumption, investment, output, employment, prices, real interest rate and employment.

4. (10 marks) Now, suppose that, right after the reduction in P, and before the implementation of fiscal austerity, the real interest rate was near the ZLB (rt = it e t+1 with it 0). How would your answer to the previous question change? What are the macroeconomic risks of implementing fiscal austerity in this context? What policy would you have preferred to stabilise the economy around potential output instead?

5. (10 marks) Suppose now that the ZLB binds. Bad news hit the world. A fraction of the labor force is infected with a deadly virus. Besides the decline in labor force, there is an increase in macroeconomic uncertainty, and governments start implementing restrictions on social gathering. These 3restrictions imply that, given existing inputs K, N, firms will be able to produce less output Y . Describe the macroeconomic effects of the virus using our five graphs' model.