In 2008, the Federal Reserve faced a decrease in aggregate demand caused by the housing and nancial crises and a decrease in short-run aggregate supply caused by rising commodity prices (long-run aggregate supply was not aected).
(a). Starting from a long-run equilibrium, illustrate the effects of these two changes using both an AS-AD diagram and a Phillips-curve diagram. On both diagrams, label the initial long-run equilibrium as point A and the resulting short-run equilibrium as point. For each of the following variables, state whether it rises or falls, or whether the impact is ambiguous: output, unemployment, and the price level.
(b). Suppose the Fed responds quickly to these shocks and adjusts monetary policy to keep unemployment and output at their natural rates. What action would it take? On the same set of graphs from part (a), show the results. Label the new equilibrium as point C.