Question 3: The AS-AD model (20 points)

Consider the AS-AD model discussed in the course. Assume that the interest rate only affects investment, not net exports. The AS and AD curves are given by

?E = ? ? ? ? ( ? ? ?K ) ""

?=? +??E+? " "L1 "

1. What must be true of the model parameters and variables in the long-run equilibrium, i.e. in the steady state? Motivate your answer. (4 points)
2. Analyse the effects of making the inflation target less ambitious, i.e., by raising ?K. Describe the mechanisms that bring the economy to long-run equilibrium. (6 points)
3. Explain how the AS and AD curves are affected if we allow for a mechanism whereby the interest rate affects the exchange rate. (4 points)
4. Should governments try to offset shocks to supply and demand by means of fiscal policy? Are there any risks involved in doing so? No formal analysis is required but please motivate your answer. (6 points)

Question 3: The AS-AD model (20 points) Consider the AS-AD model discussed in the course. Assume that the interest rate only affects investment, not net exports. The AS and AD curves are given by Ye = a - Bu(nit - it)a. What must be true of the model parameters and variables in the long-run equilibrium, i.e. in the steady state? Motivate your answer. (4 points) b. Analyse the effects of making the inflation target less ambitious, i.e., by raising i. Describe the mechanisms that bring the economy to long-run equilibrium. (6 points) c. Explain how the AS and AD curves are affected if we allow for a mechanism whereby the interest rate affects the exchange rate. (4 points) d. Should governments try to offset shocks to supply and demand by means of fiscal policy? Are there any risks involved in doing so? No formal analysis is required but please motivate your answer. (6 points)