Suppose economy starts with GDP at potential, the real interest rate and marginal product of capital both equal to 3% ad a stable inflation rate of 2%. A MILD FINANCIAL VRISES HITSTHAT CREATES FINANCIAL FRICTION THERBY CREEATING A 2% GAP BETWEEN WHAT TH ECENTRAL bank intends the real rate of interest to be and what actually prevails in the marketplace.
(a) Analyze the effect of this shock in IS/MP diagram.
(b) What policy response would you recommend to fed? What would be the effect of those policy responses on the economy?
(c) How would your answer to b change if the financial crises were cery severe, raising the financial friction to 6%?
(c) What other policy responses might be considered in this case?