Using the AD-AS framework consider the following scenario. The economy is operating at full employment when an unanticipated crisis hits the banking sector that results in a credit squeeze.

a. Explain in detail how this event in the financial system is likely to impact the real economy and what will be the implications for unemployment and inflation in the short term. In your answer be sure to also address which components of the AD-AS model may be impacted by this scenario. Your answer should be around ½ page.

b. Using the diagram below, illustrate how this scenario will:

i) Influence equilibrium in the short run (SR) labelling the new SR equilibrium A.

ii) Influence equilibrium in the long run (LR) assuming no government or policy intervention labelling the new LR equilibrium B.