Question: In this question we will analyze the following statement, and show what would happen if the advice given was followed by the Fed: "The increase in the stock market has increased people's wealth. As a result, their consumption has increased, increasing aggregate demand and output. So the Fed needs to increase the money supply, since with higher income, people's demand for real money balances will be higher."
a) State what happens to the FE and IS curves. Explain with the help of graphs what happens in the short-run to the expected real interest rate, output and employment, consumption, savings and investment (If necessary assume that the shift of the FE line is smaller than the shift of the IS curve).
b) Explain with the help of graphs how the economy converges to the general equilibrium after the shock.
c) Explain with the help of graphs what the Fed should do in order to avoid a change in output.
d) What happens to the expected real interest rate, output and employment, consumption, savings, investment and prices once prices become perfectly flexible?
e) Once prices become perfectly flexible, what should the Fed do in order to maintain prices constant?
f) Use your findings to comment the statement.