Question: 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). : To illustrate that shock, use AE/PC Model (carefully labeled!!) without time lags (use the AE and PC graphs similarly to the one attached below, 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 (? = ?^T). 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): 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).

(A) Output / chosen by central bank AE Equilibrium Y Y (B) Inflation PC Equilibrium * In the short run, the central bank chooses the real interest rate. The real rate and the AE curve determine output (A). Output and the Phillips curve determine inflation (B). Here, output is below potential and inflation is below expected inflation