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For exercises in which you are asked to illustrate using a graph, please utilize the templates associated with the specific market in question (i.e. market for bonds, market for bank reserves, AD/AS framework, etc.). These are provided with the course documents. Place the new curves in the appropriate position on the graph to illustrate the effect of any shifts.

Short-Run Equilibrium
SRAS
Ï€*
AD
Y*
Long-Run Equilibrium
LRAS
SRAS
Ï€*
AD
Y*
Factors Shifting AD
•
•
•
•
•
•
•
Autonomous monetary policy
Government purchases
Taxes
Autonomous net exports
Autonomous consumption
Autonomous investment
Financial frictions
Factors Shifting AS
• Long-Run AS
• Shocks to natural rate of unemployment
• Shocks to technology
• Shocks to long-run changes in labor or capital
• Short-Run AS
• Expected inflation
• Price shocks
• Persistent output gaps
Short-Run Aggregate Supply
Objectives of Monetary Policy
1. Stabilize Economic Activity
• Minimize output gap: (Y-Yp)
2. Stabilize Inflation
• Minimize inflation gap: (𝜋-𝜋T)
Adjustment to Long-Run Equilibrium in
AD/AS Analysis
• Demand Shocks
• Temporary Aggregate Supply Shocks
Short-Run Effect: Demand Shock
LRAS
SRAS
Ï€
2
Ï€*
AD2
AD1
Y* Y2
Long-Run Adjustment: Demand Shock
LRAS
SRAS2
SRAS1
Ï€
3Ï€
2
Ï€*
AD2
AD1
Y3 Y2
Short-Run Effect: SRAS Shock
LRAS
SRAS2
SRAS1
Ï€
2
Ï€*
AD1
Y2 Y*
Long-Run Adjustment: SRAS Shock – Optimistic?
LRAS
SRAS2
SRAS3
Ï€
2
Ï€
3
AD1
Y2 Y3
Long-Run Adjustment: SRAS Shock – Possible?
LRAS
SRAS3
SRAS2
SRAS1
Ï€
3
Ï€
Ï€*
2
AD1
Y3 Y2 Y*
Possible Responses to AD and AS Shocks
• Negative Demand Shock
• No policy response
• Policy stabilizes output in the short-run
• Negative Temporary Supply Shock
• No policy response
• Policy stabilizes inflation in the short run
• Policy stabilizes economic activity in the short run
Short-Run Effect: Negative AD Shock
Consumer Confidence declines
Real
Interest
Rate, r
MP
r*
r2
LRAS
SRAS
π2 π*
Inflation
Rate, π
Ï€*
Ï€2
AD1
AD2
Y2
Y*
Long-Run w/out Policy: Negative AD Shock
Consumer Confidence declines
Real
Interest
Rate, r
MP
r*
r2
r3
LRAS
SRAS
SRAS2
π3 π2 π*
Inflation
Rate, π
Ï€*
Ï€2
Ï€3
AD1
AD2
Y2
Y3
Policy Response: Negative AD Shock
Consumer Confidence declines – Stabilize output gap
Real
Interest
Rate, r
Policy also stabilizes
the inflation gap!
MP
MP2
r3
r2
LRAS
SRAS
π2 π3
Inflation
Rate, π
Ï€3
Ï€2
AD3
AD2
Y2
Y3
Short-Run Effect: Negative SRAS Shock
Oil prices rise dramatically
Real
Interest
Rate, r
MP
r2
r*
LRAS
SRAS2
SRAS
π* π2
Ï€2
Inflation
Rate, π
Ï€*
AD1
Y2
Y*
Policy Response: Negative SRAS Shock
Oil prices rise dramatically – Stabilize inflation gap
Real
Interest
Rate, r
MP2
Policy worsens the
output gap!
MP
r2
r*
LRAS
SRAS2
SRAS
π3 π2
Ï€2
Inflation
Rate, π
Ï€3
AD1
AD2
Y3 Y2
Y*
Policy Response: Negative SRAS Shock
Oil prices rise dramatically – Stabilize output gap
Real
Interest
Rate, r
Policy worsens the
inflation gap!
MP
MP2
r2
r3
LRAS

SRAS2
SRAS
π* π2 π3Inflation
Rate, π
Ï€3
Ï€2
Ï€*
AD2
AD1
Y2
Y3
In-Class Exercise #1
What happens to equilibrium output and inflation in the
U.S. in the short run?
What happens in the long-run if no other policy action
is taken?
1. Congress announces the first-time homebuyer tax
incentive.
2. The European economic crisis and the potential
Grexit caused a lot of unrest in the Eurozone,
causing the value of the euro to depreciate against
the dollar.
3. The Fed implements a monetary policy easing.
In-Class Exercise #2
What happens to equilibrium output and inflation in the
U.S. in the short run?
What happens in the long-run if no other policy action
is taken?
1. Removing sanctions and trade restrictions with
Iran allow the country to reopen its oil producing
sectors to international trade.
2. James Bullard, with a reputation of being an
inflation dove (willing to accept slightly higher
inflation in order to combat weakening economic
activity) was appointed the chair of the Federal
Reserve.
In-Class Exercise #3
If large budget deficits cause the public to
think there will be higher inflation in the future,
what is likely to happen when budget deficits
rise?
In-Class Exercise #4
In recent years, some Fed officials discussed
the possibility of increasing interest rates as a
way of fighting potential increases in
expected inflation.
If the public came to expect higher inflation
rates in the future, what would be the effect?
In-Class Exercise #5
Consider the situation facing the Eurozone in
the summer of 2015 when Greece was on
the verge of defaulting on its debt payments.
a. Suppose you are the chairman of the European
Central Bank (ECB) and wish to use monetary
policy to address the economic situation in
Greece. Would you enact a tightening or easing
of monetary policy?
b. What does the ECB actually do?
c. What are the effects of this policy?
How Actively Should Policymakers Respond
to Shocks?
• Non-Activists: believe that government action is
unnecessary to stabilize economic activity because
wages and prices are very flexible
• Activists (particularly Keynesians): argue that the
government should pursue active policy to
eliminate high unemployment because wages and
prices are sticky and slow to adjust
Why might policy do more harm than good?
• Data lag
• Recognition lag
• Legislative lag
• Implementation lag
• Effectiveness lag
In-Class Exercise #6
Suppose that the policymakers inaccurately assume a
natural rate of unemployment equal to 4% when the
true natural rate is 6%.
Assuming that the economy is already at its long-run
equilibrium (unemployment = 6%), what type of policy
action might result?
What happens to output and inflation in the short and
long run?
In-Class Exercise #6
Real
Interest
Rate, r
MP
MP2
SRAS2
LRAS
r*
r2
SRAS
Ï€3
Ï€2
Ï€*
π* π2 π3Inflation
AD2
Rate, π
AD1
Y* YT
U*=6%
UT=4%

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