2. a) (30 POINTS) In thisquestion, we are going to compare the size of the Government spendingmultiplier under two different assumptions: i) the Fed sits on their hands sothat when G rises, r rises with it (the standard case), and ii) the Fedaccommodates the (real) shock to money demand so that real interest ratesremain constant. In the space below, draw 4 diagrams(label them 1 through 4) with 1) a closed economy desired saving; desiredinvestment diagram, followed by 2) an IS – LM diagram followed by 3) a moneymarket diagram followed by 4) an aggregate supply ; aggregate demanddiagram. We begin at our initial pointA which is at an output well below potential GDP (i.e., there is a significant’output’ gap). We let G rise and with the assumption that the Fed sits on theirhands (assumption i) above) we move topoint B, which corresponds to an output closer to potential GDP, but still notquite there. We then assumeassumption ii) above so that the Fed accommodates the real shock to moneydemand to keep real interest rates constant. This assumption takes us to point C, which is at potential GDP (i.e.,the output gap is gone!). Start at an initial equilibrium and label as pointA in all diagrams, with all the associated market clearing variables denoted bysubscript A. For example, in your IS –LM diagram, the interest rate that clears the goods and money market is labeledas rA with the associated output at YA. Note importantlythat we are assuming fixed pricesthroughout this exercise. Now let G rise to G’ and show how all your graphs areaffected. In particular, locate point B inall graphs making sure you refer toeach graph separately explaining the intuition of the movement from point Ato point B. Note, we are assumingassumption i), the Fed sits on their hands and does not accommodate the shockto real money demand.2. b) (20 points forexplanation) We now apply assumption ii), the one Romer and Bernstein use’that the funds rate is likely to be at or near its lower bound of zerofor the foreseeable future.’ In terms of our analysis, the Fed is going tomake sure that real rates remain at their initial level (i.e., they totallyaccommodate the real shock to money demand). Show this accommodation as point Con all of your diagrams. Recall that we are at full employment/potential GDP atpoint(s) C. Again, make sure you refer to each graph separately explaining the intuitionof the movement from point B to point C. 2.c) (20 points) Now comparethe government spending multiplier under assumption i) no Fed accommodation andii) the Fed accommodates the real shock to money demand. Be specific with regard to the multiplier aswell as the intuition. To support your intuition, draw two diagrams: the usercost = MPKf and the two period consumption model clearly locatingpoints A, B, and C. Referring to your 2graphs, explain the intuition as to why we move from point A to point B as wellas why we move from points B to C. Be sure to label your graphs completely orpoints will be taken off. Make sure yourelate your discussion of your two graphs to the difference in the multiplierdepending on what the Fed does or doesn’t do.2.d)(25 POINTS) The real business cycle economists (RBC theory) came up with astory that explains exactly why money is a leading and pro-cyclicalvariable. In the space below, draw amoney market diagram on the left, an IS/LM diagram on the right (labelcompletely) and an aggregate demand / aggregate supply diagram below the IS/LMdiagram. Discuss how the real businesscycle economists (RBC) addressed this empirical reality (explain using yourdiagrams). Starting at the initial equilibrium, point A, let the shock that theRBC theorists use to explain this money – output correlation occur and assumingthe Fed does not react, locate thenew equilibrium as point B (assume prices are perfectly flexible, consistentwith RBC theory). Comment on the desirability of this adjustment in the contextof the Fed’s price stability objective, from a monetary policy perspective, andfrom a macroeconomic perspective (i.e., behavior of consumers and firms). Nowconsider the case where Fed does their job (recall, the Fed takes their dual mandate extremely seriously) so that theseundesirable results do not occur and label as points C. Is money leading andpro-cyclical given the Fed’s behavior? Explain.Why is this model referred to as reverse causation? Finish your essay by commenting on how RBC economists explain the business cycle(recurrent fluctuations in output) as well as their thoughts on whether or not policymakers, both monetaryand fiscal policymakers should conduct active counter-cyclical policy.2.e) (25 POINTS) The New-Keynesians came up with theirown story as to why we observe this positive money – output correlation. Beginwith discussing why the New Keynesians believe that prices are sticky in asmuch detail as possible. Then use theefficiency wage theory/model to buttress (support) your argument (i.e., why does the efficiency wage theory play acritical role in explaining why firms are willing to produce more output at thesame price?) Draw two graphs, oneshowing the effort curve and the efficiency wage (be sure to explain how firmspick the efficiency wage) and the other being a labor supply- labor demanddiagram with the assumption that the efficiency wage (w*) is above the marketclearing (classical) wage (wclass). Why is this model so attractive in dealing with the empirical reality inlabor markets that the classical school has such a hard time with and what isthe empirical reality we are referring to? Now draw two more diagrams depicting what is happening in the productmarkets (demand, marginal revenue, marginal cost and profits) and why firms are willing to change output atthe given price level (short run), given a positive shock to (aggregate)demand? Be clear as to why exactly firms are willing to act like a ‘vendingmachine’ in the short run (be willing to increase