Graphical analysis of aggregate demand and supply with the given market condition.
Suppose that the Fed has a policy of increasing the money supply when it observes that the economy is in recession. All firms understand this policy. However, suppose that about six months are needed for an increase in the money supply to affect aggregate demand, which is about the same amount of time needed for firms to review and reset their prices. Please provide brief and concise answers to the following problems.
a) Illustrate what effects will the Fed's strategy have on output and price stability? Will the Fed be successful at combating recessions?
b) Does your answer in (a) change if the Fed has some ability to forecast recessions? Assume that the firms do not have the same forecasting ability, and that they do not observe movements in the money supply.
c) Does your answer in (a) change if price adjustment takes longer than six months?