The textbook discusses how monetary policy and fiscal policy can interact. A variant of the IS-LM model replaces adds a new equation, a monetary policy rule, that specifies how the money supply will be managed as a function of economic conditions.

Consider an economy with the IS curve Y = 14 - 2r + 3G, money demand L = 3 - r, and a central bank considering two different monetary policy rules:

rule A: M/P = 1 + 0.5(10 - Y)

rule B:M/P = 1 + 0.25(10 - Y)

i. For each rule, find the monetary policy (MP) curve (MP curve is the new name for the LM curve when using a monetary policy rule) then calculate how much output would increase in response to a $1 increase in government purchases.

ii. Discuss economic intuition for why a fiscal expansion has a larger effect on output with rule B.