Question

1. Suppose the economy starts out in a long-run equilibrium at potential GDP..
   1. Draw the economy’s short-run and long-run Phillips curves in one graph an AS/AD diagram with potential GDP shown in a second graph.
   2. Suppose a wave of business pessimism reduces aggregate demand. Show the effect of this shock on your diagrams from part a). Can the government return the economy to its original inflation rate and original unemployment rate using fiscal policy?
   3. Now start over with the economy back in long-run equilibrium, and suppose the price of imported oil rises. Show the effect of this shock with new diagrams like those in part a). Can the government return the economy to its original inflation rate and original unemployment rate using fiscal policy? Explain why this situation might differ from that in part b).

Answer 1

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