Consider a different version of the Taylor rule, where monetary policy depends onlyon short-run output: −  =  ea) Draw an IS-MP diagram, but instead of the usual MP curve, plot the simplifiedversion of the Taylor rule. You might label this curve MPR for “monetarypolicy rule”.b) Now consider the effect of a positive aggregate demand shock in the IS-MPRdiagram. (An example might be a fiscal stimulus.) Compare and contrast theeffect of this shock on the economy in the standard IS-MP diagram versus theIS-MPR diagram. Why is the result different?c) Economists refer to the result in the IS-MPR diagram as “crowding out”. Whatgets crowded out and why?

a) To draw an IS-MP diagram with the simplified version of the Taylor rule, you would start by drawing your standard IS curve, which shows the relationship between output and the real interest rate when goods market is in equilibrium. The IS curve slopes downward because as the real interest rate decreases, investment increases, leading to an increase in output.

Next, instead of drawing the usual MP curve, you would plot the simplified version of the Taylor rule. This curve, which we can label MPR for "monetary policy rule", would be a vertical line because the Taylor rule in this case only depends on output, not on the interest rate. The position of the MPR curve would depend on the parameter n in the Taylor rule.

b) A positive aggregate demand shock, such as a fiscal stimulus, would shift the IS curve to the right in both the standard IS-MP diagram and the IS-MPR diagram. This is because the fiscal stimulus increases output at any given interest rate.

In the standard IS-MP diagram, the interest rate would also increase as a result of the shift in the IS curve. This is because the central bank responds to the increase in output by raising the interest rate to prevent inflation.

In the IS-MPR diagram, however, the interest rate does not change in response to the shift in the IS curve. This is because the Taylor rule in this case does not depend on the interest rate, only on output. Therefore, the increase in output does not lead to an increase in the interest rate.

c) The result in the IS-MPR diagram is referred to as "crowding out" because the increase in output due to the fiscal stimulus does not lead to an increase in the interest rate. This means that the fiscal stimulus "crowds out" private investment, because the increase in government spending does not lead to a corresponding increase in the interest rate that would make private investment more attractive. The reason for this is that the central bank does not respond to the increase in output by raising the interest rate, as it would in the standard IS-MP model.