Task: Suppose that both the stock market and housing prices fall in the U.S.
1. First, explain the channels through which these shocks affect aggregate demand for goods and services.
2. Second, with the help of an IS-LM graph, explain the effect of these shocks on 1) real GDP, 2) the interest rate, 3) the exchange rate and on 4) the composition of demand.
3. Suppose the Fed wants to use open market operations to offset the effect on real GDP. What would it do? With the help of an IS-LM diagram, explain the effects of Fed policy if it works.
4. Explain why Fed policy might not be effective.
5. Next, consider fiscal stimulus as an alternative to monetary stimulus. With the help of an IS-LM diagram, explain the effects of the fiscal stimulus that you choose.