Suppose now that in addition to the negative wealth effect described in (1), the housing bust...

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Suppose now that in addition to the negative wealth effect described in (1), the housing bust triggers severe disruptions in financial intermediation due to financial panics as was the case during the Great Recession of 2007-2009. That is, the supply of credit to firms, who rely on bank credit for financing there investment projects, significantly falls. Suppose that the combined fall in aggregate demand (consumption + investment) is so large that it pushes the economy into Liquidity Trap (that is, nominal interest rates hit Zero Lower Bound, ZLB). a. Use the modified IS-LM framework that incorporates ZLB to show the effects of the shock on income (output) and interest rates. On a separate diagram, show the effect of this same shock of the same magnitude on income (output) when the ZLB does not bind. How does this effect compare with the one under the binding ZLB? Use graphs to illustrate your answers. b. Now suppose that the government wants to mitigate the short run negative effects of this combined large shock which pushes the economy into liquidity trap. That is, the after- shock short-run equilibrium is now on the flat part of the LM curve. With the help of the modified IS- LM model (with ZLB) analyze monetary and fiscal policies. Which policy is more effective at bringing the economy's output back to its initial (pre-shock) equilibrium? You can analyze each policy on a separate graph. Starting from the aftershock equilibrium point, show how each policy can affect the economy's output and which policy is more effective at doing so. Explain in words (that is, provide intuition of) how and why equilibrium output and interest rate change in response to each policy. Clearly label the graphs. c. Now suppose that the Federal Reserve can credibly commit to any future inflation target. Describe the policy that the Fed should pursue to get the economy out of the liquidity trap. Use the graph to illustrate Suppose now that in addition to the negative wealth effect described in (1), the housing bust triggers severe disruptions in financial intermediation due to financial panics as was the case during the Great Recession of 2007-2009. That is, the supply of credit to firms, who rely on bank credit for financing there investment projects, significantly falls. Suppose that the combined fall in aggregate demand (consumption + investment) is so large that it pushes the economy into Liquidity Trap (that is, nominal interest rates hit Zero Lower Bound, ZLB). a. Use the modified IS-LM framework that incorporates ZLB to show the effects of the shock on income (output) and interest rates. On a separate diagram, show the effect of this same shock of the same magnitude on income (output) when the ZLB does not bind. How does this effect compare with the one under the binding ZLB? Use graphs to illustrate your answers. b. Now suppose that the government wants to mitigate the short run negative effects of this combined large shock which pushes the economy into liquidity trap. That is, the after- shock short-run equilibrium is now on the flat part of the LM curve. With the help of the modified IS- LM model (with ZLB) analyze monetary and fiscal policies. Which policy is more effective at bringing the economy's output back to its initial (pre-shock) equilibrium? You can analyze each policy on a separate graph. Starting from the aftershock equilibrium point, show how each policy can affect the economy's output and which policy is more effective at doing so. Explain in words (that is, provide intuition of) how and why equilibrium output and interest rate change in response to each policy. Clearly label the graphs. c. Now suppose that the Federal Reserve can credibly commit to any future inflation target. Describe the policy that the Fed should pursue to get the economy out of the liquidity trap. Use the graph to illustrate

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