Answer the questions below.
a.Suppose the economy is initially in long-run equilibrium in the AD-AS model. Draw a diagram showing long-run equilibrium, including the AD, LRAS, and SRAS curves. b.Now suppose stock prices decline sharply. Draw a new diagram showing the AD, LRAS, and SRAS curves. How have the level of output and the price level changed? What happens to consumption spending and investment spending? c.Redraw your diagram from part b, then draw new lines to show what would happen if the Fed changed monetary policy to return the economy to full-employment equilibrium. Does the money supply increase or decrease? Which curve (AD, LRAS, or SRAS) shifts as a result of the Fed's policy change? What happens to the price level and level of output compared with what they were in part b? What happens to consumption spending and investment spending compared with what they were in part b?
What will be an ideal response?
| a. | Standard diagram from the textbook. |
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| b. | The decline in the stock market shifts the AD curve to the left, so output and price level both decline. The decline in output reduces both consumption spending and investment spending. Standard diagram. |
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| c. | When the Fed increases the money supply, the long-run equilibrium is restored by shifting the AD curve to the right. The price level and level of output are higher than they were in part b; as a result, consumption and investment are also higher. Standard diagram from the textbook. |
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