Question 3 (4 points): Illustrate a permanent decrease in government spending

(let's say infrastructure spending freeze) implemented in 2022. For simplicity,

assume there are no time lags.

a). (2 point): To illustrate that shock, use AE/PC Model (carefully labeled!!)

without time lags (use the AE and PC graphs similarly to the textbook, place PC

graph below AE graph). For your analysis, choose as a starting point (marked A)

an economy operating at potential GDP (Y=Y*) and at its inflation target ( =

#). Also, show point B where the economy is situated after the shock but prior to

any central bank policy response. There should be A and B on BOTH the upper

(AE graph) and lower (PC graph) graphs. If points A and B are the same point,

then just mark that point with both A and B. Mark initial curves with the

superscript 1, like AE1 and PC1, and every subsequent shift with a higher number,

like the second shift would be AE2 and PC2, and the third shift (if necessarily)

would be AE3 and PC3 and so on.

b). (2 point): Now, illustrate that counter-cyclical monetary policy has been

implemented by the central bank. Again, use AE/PC Model (new set of graphs!).

Now your initial point is point B, mark the response as point C. There should be a

points B and C on both the upper graph and the lower graph, even if they are in the

same location. You can stop your analysis when the economy is stabilized (Y=Y*

again).

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