Questions -

Q1. If lager deficits cause the public to think there will be higher inflation in the future what is likely to happen to short run aggregate supply curve if budget deficits rise?

Q2. When aggregate output is below potential output what happens to the price level over time? Why? Assume a constant aggregate demand curve.

Q3. "Because government policymakers do not consider inflation desirable their polices cannot be the source of inflation and higher prices". is this statement , true , false or uncertain?

Q4. Suppose the economy is at a long-run equilibrium that is experiencing 4% inflation. How could the central bank effectively target a 2% inflation rate? Can they also target output in the long run? Draw a graph to illustrate.

Q5. Classify each of the following as supply shock or demand shock. Explain why the relevant curve will be affected and how. Then beginning from a long run equilibrium use a graph of the AD-AS model to show the effects on inflation and output in the short run and the long run. Label the initial equilibrium point 1 the new short run equilibrium point 2 and the new long run equilibrium point 3. Assume there is no policy intervention by the federal reserve.

a. Increase consumer confidence results in higher consumer spending.

b. Favorable weather produces a record high crop of grains in the united states.

c. Large in subprime mortgages leads to panic and turmoil in financial markets.

Q6. Suppose the economy is at a long run equilibrium with inflation equal to the central banks target when the price of steel increases.

a. What happens in the short and long run if the federal reserve dose not take any action?

b. What should the fed do if they want to stabilize inflation after the shock? What happens in the short and long run as a result and why?

c. What should the fed do if they want to stabilize output after the shock? What happens in the short and long run as a result and why?

d. Compare and contrast your answers from b and c.

Q7. Suppose the economy is at a long -run equilibrium with inflation to the central banks target when financial frictions increase.

a. Use a graph of the AD-AS model to illustrate the short run effect of this shock. Label the initial equilibrium point 1 and the new short run equilibrium point 2. What happens to output, inflation and unemployment?

b. Suppose the fed does not take any corrective action. In words, what happens in the long run? If any curves shift briefly explain why. Illustrate the long run transition in your graph and label the new long run equilibrium point 3.

c. Now suppose the fed does take correction action. Given the short run equilibrium from part a what is the appropriate open market operation the central bank should conduct? What is the effect of this action on interest rates?

d. In words, what is the effect of the policy action on aggregate demand? Make sure to specify what components of aggregate demand are affected, how they are affected and why.

e. Illustrate the effect of the policy action in your graph from part a. (you can also draw a second graph if you want.) label the new long run equilibrium point 4.

f. Compare and contrast the long run outcomes under do policy action (part b) and policy action (part e).