Assume that the economy starts at a 0% output gap. Now suppose that banks begin to fear the risk of default and the risk premium rises by 2%. Which of the following figures shows what happens in this scenario?

Figure A

Figure B

Figure C

Figure D

A)Figure A (no change)
B)Figure B (an upward shift of the MP curve and a new interest rate of 3%)
C)Figure C (a leftward shift of the IS curve and an output gap of -4%)
D)Figure D (an upward shift of the Phillips curve and 1% unexpected inflation)

Question

Assume that the economy starts at a 0% output gap. Now suppose that banks begin to fear the risk of default and the risk premium rises by 2%. Which of the following figures shows what happens in this scenario?
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Figure A
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Figure B
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Figure C
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Figure D

A)Figure A (no change) 
B)Figure B (an upward shift of the MP curve and a new interest rate of 3%) 
C)Figure C (a leftward shift of the IS curve and an output gap of -4%) 
D)Figure D (an upward shift of the Phillips curve and 1% unexpected inflation)

Quizplus · Accepted Answer

An increase in the risk premium will cause an upward shift of the MP curve, as shown in Figure B. This will lead to a new equilibrium interest rate of 3%. There is no reason to believe that the IS curve or Phillips curve would shift in response to this shock, so Figures C and D can be eliminated. Figure A does not take into account the change in the risk premium, so it is also incorrect.

Assume That the Economy Starts at a 0% Output Gap