During 2020 and 2021, the government implemented large fiscal stimuli. During those years however lockdown policies were strict so people didn't have much spending ability.
Q0 (3 points). Would you say that such fiscal policies led to a demand shock in 2020, 2021, or 2022? Explain when would the demand shock appear, why and which sign it would have. (Assume that the Ricardian Equivalence does NOT hold).
Exercise with a negative demand shock.
Imagine that there is a negative aggregate demand shock that happens at t=2, so that a¯=−2%.
Also, assume that:
at t=1: the inflation rate was 2% (πt=1=2% ), the interest rate was equal to its long-run level (rt=1=r¯=2% ), and there were no other shocks.
Use the following values for the parameters: b=2 , v¯=1, r¯=2%.
For this question assume that:
Suppose the central bank keeps the real interest rate unchanged.
Answer the following:
Q1 (5 points). Use the IS-MP diagram and the Phillips curve to show what happens to the economy at t=2.
Q2 (5 points). Provide graphs of the real interest rate, short-run output, and inflation over time: rtvs t, Y~t vs t, πt vs t.
Your graphs should show these variables for t=1,2, and 3.
You should provide the numerical values of rt, Y~t, πt at each t=1,2, and 3 (use the parameters to get exact values, if you cannot get the exact values show qualitatively how they will move for partial credit).
Now, imagine that the Central Bank cannot change the rate. Suppose instead that you can implement fiscal policy. Answer the following:
Q3 (3 points). What fiscal policy action would you take? Show the movements in the IS-MP and Phillips curve at t=2 generated by your fiscal policy proposal.
No need to show numerical values here
