A financial crisis substantially raises the risk premium (i.e. financial frictions increase) and simultaneously makes households and firms pessimistic about the economy, decreasing autonomous consumption and investment. Assume the shock is so large that the nominal interest rate reaches zero, the economy's zero lower bound. a) Draw the MP curve, IS curve, and AD curve below and above the zero lower bound. Describe why the slope of the MP and AD change at the zero lower bound. b) Explain using words and graphs how the economy responds to this large shock in the absence of government intervention. What are the economy's typical self-correcting mechanisms in normal times? In these circumstances, do they return the economy to potential output. Why or why not? c) Describe the actions that the Federal Reserve took in response to the financial crisis of 2008-9 after the economy reached the zero lower bound. Use AD-AS diagrams to explain how these policies helped the economy recover after the economic and financial tsunami. e
A financial crisis substantially raises the risk premium (i.e. financial frictions increase) and simultaneously makes households and firms pessimistic about the economy, decreasing autonomous consumption and investment. Assume the shock is so large that the nominal interest rate reaches zero, the economy's zero lower bound. a) Draw the MP curve, IS curve, and AD curve below and above the zero lower bound. Describe why the slope of the MP and AD change at the zero lower bound. b) Explain using words and graphs how the economy responds to this large shock in the absence of government intervention. What are the economy's typical self-correcting mechanisms in normal times? In these circumstances, do they return the economy to potential output. Why or why not? c) Describe the actions that the Federal Reserve took in response to the financial crisis of 2008-9 after the economy reached the zero lower bound. Use AD-AS diagrams to explain how these policies helped the economy recover after the economic and financial tsunami. e
Chapter1: Making Economics Decisions
Section: Chapter Questions
Problem 1QTC
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