Assume that an economy is in the long-run equilibrium with the GDP deflator of 150 and potential output of $40 billion. Draw a typical aggregate demand-aggregate supply model using this information. Explain each curve/line.

a. The economy is experiencing a shock – a sharp drop of stock prices.

i. Show on the graph what happens in the short run. Explain.

ii. What type of output gap is this? Calculate the output gap.

b. Explain what will happen in the long run due to self-correction. Show the appropriate shift on the graph.

c. What problem is the economy facing?

d. The government decides to intervene. What policies should it implement? What is the goal of these policies?

e. What is the most challenging shock for the policy makers to deal with? Explain why.