Assume the economy is currently at potential output. Then, a major increase in stock prices makes consumers feel wealthier, leading them to increase their consumption spending.

a) What does it mean for the economy to be at “potential output”? What determines the potential output?

b) Use the Aggregate Supply and Demand model to analyze the short-run impact that this new policy will have on real GDP and the price level. This is the “Shock.”

c) Assuming no other changes in policy, describe how this policy will affect real GDP and inflation in the long-run. Start with your answer to part b), and describe how the economy moves to its new long-run equilibrium. Response, New Equilibrium.

Answer rating: 100% (QA)

a Potential Output Potential output is the maximum sustainable level of real GDP that an economy can ... View the full answer