3 questions of intermediate quantitative economics

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1. IS-MP-AD-IA model. In order to help the U.S. economy, President Trump has argued that Congress should pass a substantial payroll tax cut (which would reduce the amount of taxes being taken out of workers’ paychecks). Assume that the economy starts out at potential output.

  1. a) According to the IS-MP model, what would happen to output and the real interest rate in the short run? Draw a diagram to help explain your answer. (Note that this part is just a quick repeat of question 4b from Problem Set 4 to get us started.)
  2. b) What would happen to the AD and IA curves in the short run? Draw a diagram to help explain your answer. What happens to output and inflation in the short run?
  3. c) According to the IS-MP-AD-IA model, what should happen to output and inflation over time? Draw a diagram to help explain your answer.
  4. d) If the tax cuts are permanent, what would be the long-run effect of the tax cut in the AD- IA and IS-MP diagrams? Draw those diagrams to explain your answer.
  5. e) What would be the long-run effect of the shock on output, inflation, and the real interest rate? What would be the long-run effect on consumption, investment, and government purchases? Briefly explain why.
  6. f) Suppose that the economy starts out below potential output instead of at potential output. Moreover, suppose that after the tax cut, the economy is still below potential output in the short run. What are the main benefits of the tax cut in this case?

2. IS-MP-AD-IA model. Prior to the coronavirus crisis, President Trump was very critical of the Federal Reserve and its chairman, Jerome Powell. Suppose that Chairman Powell resigned and was replaced with a new Federal Reserve Chairman who is less worried about inflation and sets interest rates lower than before. Assume that the economy starts out at potential output.

  1. a) What would happen to the real interest rate and output in the short run, according to the IS-MP model? Draw a diagram to help explain your answer. (Again, this part is just a quick repeat of question 5b from Problem Set 4 to get us started.)
  2. b) What would happen to the AD and IA curves in the short run? Draw a diagram to help explain your answer. What happens to output and inflation in the short run?
  3. c) According to the IS-MP-AD-IA model, what would happen to output and inflation over time? Draw a diagram to help explain your answer.
  4. d) Assuming the Fed maintains this new monetary policy rule indefinitely, what would happen to the AD-IA and IS-MP diagrams in the long run? Draw those diagrams to explain your answer.
  5. e) What is the long-run effect of the shock on output, inflation, and the real interest rate? What is the long-run effect of the shock on consumption, investment, and government purchases? Briefly explain why.

3. IS-MP-AD-IA model. In 2020, oil prices have fallen dramatically, from about $60/barrel to $12/barrel, a huge decline. For simplicity, let’s assume that the economy was starting from steady state, so that output was equal to potential output just before the shock, and let’s

assume that the oil price shock is the only shock hitting the economy, to focus attention on the effects of that shock in particular.

  1. a) In the AD-IA diagram, which curve is initially shifted by the fall in oil prices? Explainwhich way the curve shifts, and why. Draw a diagram to help explain your answer. Whatis the short-run effect of the oil price shock on output and inflation?
  2. b) In the IS-MP diagram, what is the short-run effect of the oil price shock on the IS and MPcurves? Draw a diagram to help explain your answer. What happens to the real interestrate in the short run?
  3. c) What is the short-run effect of the shock on consumption, investment, and governmentpurchases? Briefly explain why.
  4. d) According to the IS-MP-AD-IA model, what happens to output and inflation over time inresponse to the shock? Draw a diagram to help explain your answer.
  5. e) What happens to the AD-IA and IS-MP diagrams in the long run? Draw those diagramsto explain your answer. If oil prices remain at $12/barrel for the indefinite future, whatwould be the long-run effect of that decline on output, inflation, and the real interest rate?
  6. f) What would be the long-run effect of the oil price shock on consumption, investment, andgovernment purchases? Briefly explain why.
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