Due date: Wendesday, December 6. Please submit the problem set by the beginning of the
class.
You must provide detailed explanation for your answers. Please write clearly. If your answer is
not clear, I cannot give you the credit for the question.
1. A Financial Crisis: suppose the economy starts with GDP at potential, the real interest rate and
the marginal product of capital both equal to 3 percent. A mild financial panic hits and it raises
the risk premium from zero to 2 percent. (For this question, you do not need to consider a
negative demand shock together with this financial panic.) Be sure to provide the exact value of
the real interest rate and federal fund rate for your answers. (10 points)
(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 panic was more severe,
raising the risk premium to 7 percent? Is monetary policy (via the change in interest
rate) still effective in bringing the short run output back to the level of zero? Explain
graphically (using an IS/MP diagram) as well as in words.
