Question 1 - The U.S. economy was experiencing a very prosperous combination of economic expansion and low inflation in the late 1999s. There were lots of positive factors working as causes of these unparalleled good times. Some of the reasons were recent technological improvements and increases in productivity, which were lowering the cost of production for the U.S. firms (a positive supply shock).<
a. Assume that the economy starts from an equilibrium (in the long run and in the short run). Draw the aggregate supply in the short run and in the long run, and the aggregate demand. Now, show the effect of this positive supply shock. Be sure to label i. the axes; ii. the curves; iii. the initial equilibrium values. In the same diagram, show the path the economy takes in the short run. Be sure to show i. the direction the curves shift, ii. the short-run equilibrium values.<
b. State in words what happens to prices and output in the short run.<
c. Suppose that this economic supply shock is temporary. Redraw the diagram from (a) and show how the economy moves to the long run equilibrium values. Be sure to label i. the axes; ii. the curves; iii. the direction the curve shifts, iv. the long-run equilibrium values.<
d. Now state in words what happens to prices and output in the long run<
Nevertheless, according to the LA Times of 3/2/2000, one of the biggest risks to the ongoing expansion (back then) was the prospect of interest rate hikes, as the Federal Reserve Board tried to engineer moderation in that quite strong economic growth pattern. Suppose that the Fed policymakers decreased money supply (and therefore raised interest rates) in mid 2000 to cool off the nation's roaring growth and hedge against inflation.<
e. Forget about the long run for now and redraw the diagram from a. Show the effect on the aggregate demand of this policy. Show the path the economy will take in the short run under the Fed intervention. Be sure to show i. the direction the curve shift, ii. the new short-run equilibrium values.<
f. What is the impact of this Fed's policy on prices, income, and output in the short run? What is trade-off the Fed faced? Would you recommend this policy? Explain.<
g. What would happen in the long run with this Fed intervention in the short run, given that the supply shock was temporary? Draw the graph showing this equilibrium and explain in words.