Assume that the economy is initially in equilibrium at potential GDP. Then suppose that the economy is hit simultaneously with a positive aggregate demand shock and a negative aggregate supply shock: There is a large increase in U.S. exports to Europe and a large increase in oil prices.
a. Use an AD–AS graph to illustrate the initial equilibrium and the short-run equilibrium after the shocks. Do we know with certainty whether in the new equilibrium the output level will be higher or lower than potential GDP?
b. Suppose that the Fed decides not to intervene with monetary policy. Show how the economy will adjust back to long-run equilibrium.
c. Now suppose that the Fed decides to intervene with monetary policy. If the Fed’s policy is successful, show how the economy adjusts back to long-run equilibrium.