Texts: Assume that the economy is in its long-run equilibrium. Now, suppose that the FED starts to pursue expansionary monetary policy. At the same time, the President pushes through legislation that lowers corporate income taxes.
(a) Illustrate the effects of such a policy mix on output and the real interest rate using the IS-MP model. Also describe how investment, consumption, government spending, exports, and imports change.
(b) The described policy mix describes well the policies pursued by President Bush's administration and the Federal Reserve in the beginning of 2001. What happened to output in 2001? How do you reconcile the fact that both fiscal and monetary policy were expansionary with the fact that output growth was so low in 2002? (Hint: what other major event took place in 2001 and how might this have affected the IS curve?)