Suppose the economy starts with GDP at potential, the real interest rate and the marginal product of capital both equal to 3 percent, and a stable inflation rate of 2 percent. A mild financial crisis hits that raises the financial friction from zero to 2 percent.
(a) Analyze the effect of this shock in an IS/MP diagram.
(b) What policy response would you recommend to the Federal Reserve? What would be the effect of this policy response on the economy?
(c) How would your answer to part (b) change if the financial crisis were very severe, raising the financial friction to 6 percent?
(d) What other policy responses might be considered in this case?