Macroeconomics 5th Edition by Olivier Blanchard

Exercise 4

Monetary versus fiscal policy
a. Consider an economy with output below the natural level and a nominal Interest rate equal to zero. Illustrate this economy in an IS-LM diagram.
b. Under normal circumstances, how does the economy return to the natural level of output (Refer to your answer to problem 2(b).) Does this adjustment mechanism work when the nominal interest rate equals zero
c. Suppose the central bank wants to use monetary policy to return the economy to its natural level of output. Can it do so when the nominal interest rate is equal to zero What happens if the central bank tries to use expansionary monetary policy Illustrate your answer in an IS-LM diagram.
d. In principle, can fiscal policy be used to restore the economy to its natural level of output when the nominal interest rate equals zero If so, explain how the appropriate policy affects output. If not, explain why not.
e. Consider the following policy advice: 'Because the Fed can act to keep the economy at the natural level of out-put, the federal government should never use fiscal policy to stimulate the economy." Do your answers to parts (a) through (d) support this advice