1. Suppose the Fed is considering two different policy rules, shown in the following table. Graph the
If the Fed currently is following Policy Rule 1 and then shifts to Policy Rule 2, which way will the
aggregate demand curve shift? What reasons might the Fed have for changing its policy?
2. Suppose you have the following information on the Fed’s and the European Central Bank’s policy
Fed real interest rate = 0.5(inflation rate – 2)
ECB real interest rate = 0.2(inflation rate – 2) + 1
a) Graph the policy rules. If the inflation rate is 2 percent in both countries, what will the real
interest rate be in each country?
b) Some argue that Europe has a much lower tolerance for inflation than the US. Can you tell –
either from the diagram of the equations – whether this is true?
3. State which of the following cause a shift in the aggregate demand curve and which ones are a
movement along it. Provide the direction of the change.
a) A cut in government purchases
b) A crash in the US stock market
c) A shift to a lower inflation target in the monetary policy rule
d) Being thrifty now becoming fashionable
e) An increase in the European interest rate
4. Consider an economy that is at potential output. Using the aggregate demand and the inflation
adjustment line, describe what would happen to GDP, inflation, consumption, investment and net
exports in the short, medium, and long run if the government cut spending on defense. Be sure to
provide an economic explanation for the results.
5. Suppose that an increase in government spending had the long-run effects described in problem 4.
If the central bank wants to return to the original inflation rate that existed before the increase, how
can it achieve its objective? In words and diagrams, describe the proposed change in policy and its
short, medium, and long run effects on real GDP and inflation.
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