Effect of the shock on price level, GDP and nominal interest rate during a financial turmoil and required open market operations.
Suppose that the economy is hit by the following shock: Financial turmoil leads to an increase in risk aversion by wealth holders in the sense that they want to hold more of their wealth in insured bank deposits (money) and less in bonds and stocks.
a. With the help of an AD-AS diagram, describe the effect on the price level and real GDP. Use an upward sloping AS curve and be clear about the interconnections among markets.
b. describe all of the effects that this shock will have on the (nominal) interest rate, i. No graph is required for this answer.
c. Illustrate what the Fed should do if it wants to use open market operations to offset the effect of this shock.