Suppose the economy is initially in long-run equilibrium. Due to decline in hous

Question

Suppose the economy is initially in long-run equilibrium. Due to decline in house prices, suppose that consumers reduce their consumption spending. (a) Explain how the decline in consumer spending affects the AD curve. (b) If the fed does not change its monetary policy rule, how will the fed react to the decline in consumer spending? Use an AD/AS diagram to illustrate and explain your answer. (c) Now, in addition to the decline in consumer spending, suppose that the economy experiences an adverse inflation shock. (i) Explain how the adverse inflation shock affects the AS curve. (ii) Discuss, using AD-AS diagram, what choices the Fed now must make regarding monetary policy. (Hint: Think about whether or not it should tighten monetary policy).

Explanation / Answer

-The term sticky wage is used to describe how wages can be slow to adjust and may be on the short-run for a while. This is why the short-run aggregate supply can have an equilibrium point below or above the LRAS but it adjusts over time

-A positive demand shock would create a short run increase in both GDP and price level. The economy adjusts because the higher prices lead to higher nominal wages which increases the input costs of all jobs and pushes SRAS back to long run equilibrium at a higher price.

-Fiscal policy deals with government policies (government spending and taxes) while monetary policy deals with controlling the money supply to impact interest rates (Required reserve ratio, discount rate and open market operations)

-High consumer optimism may cause demand curve to shift right

-In the short run, Real GDP and prices would fall because of a small and falling physical capital. This is considered as the investment portion of GDP. As it declines, AD shifts to the left

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