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Consider the following changes in the macroeconomy. Show how to think about them using the IS curve, and explain how and why GDP is affected in the short run. The Federal Reserve undertakes policy...

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  1. Consider the following changes in the macroeconomy. Show how to think about them using the IS curve, and explain how and why GDP is affected in the short run.
    1. The Federal Reserve undertakes policy actions that have the effect of lowering the real interest rate below the marginal product of capital.
    2. Consumers become pessimistic about the state of the economy and future productivity growth.
    3. Improvements in information technology increase productivity and therefore increase the marginal product of capital
  2. John Taylor of Stanford University proposed the following monetary policy rule: . That is, Taylor suggests that monetary policy should increase the real interest rate whenever output exceeds potential.
    1. What is the economic justification for such a rule?
    2. Combine this policy rule with the IS curve to get a new aggregate demand curve. How does it differ from the AD curve we considered in the chapter? Consider the response of short-run output to aggregate demand shocks and inflation shocks.
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Consider the following changes in the macroeconomy. Show how to think about them using the IS curve, and explain how and why GDP is affected in the short run. The Federal Reserve undertakes policy actions that have the effect of lowering the real interest rate below the marginal product of capital. Consumers become pessimistic about the state of the economy and future productivity growth. Improvements in information technology increase productivity and therefore increase the marginal product of capital John Taylor of Stanford University proposed the following monetary policy rule: Rt-r=mpt-p+nYt. That is, Taylor suggests that monetary policy should increase the real interest rate whenever output exceeds potential. What is the economic justification for such a rule? Combine this policy rule with the IS curve to get a new aggregate demand curve. How does it differ from the AD curve we considered in the chapter? Consider the response of short-run output to aggregate demand shocks and inflation shocks.

Answered Same Day Dec 31, 2021

Solution

David answered on Dec 31 2021
110 Votes
1. Consider the following changes in the macroeconomy. Show how to think about them
using the IS curve, and explain how and why GDP is affected in the short run.
A. The Federal Reserve undertakes policy actions that have the effect of lowering the
eal interest rate below the marginal product of capital.
Answer:
If marginal product of capital is higher than interest rate, then return on capital would be higher
than cost of capital. So people would like to invest more, causing investment expenditure to
increase. Since investment is important component of aggregate demand, so increase in
investment expenditure will cause IS curve to shift rightward. The rightward shift in IS curve
with no change in LM curve, would cause both GDP and interest rate to increase in the economy.
[Refer figure1]
Figure1:
B. Consumers become pessimistic about the state of the economy and future
productivity growth.
Answer:
When consumers become pessimistic about the state of the economy and future productivity
growth, they would expect their income to fall in the future and therefore they would be more
cautious while spending. So they would reduce their spending which...
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