How a drop in aggregate demand leads to a recession. In this problem, we will again examine the effects of a drop in aggregate demand. Instead of the economy returning to its long-run equilibrium through the self-correcting mechanism, however, you will write down the effects of combating the recession with expansionary monetary policy.

Specifically, you will evaluate a permanent decline in consumer confidence,which reduces household consumption, C.

Throughout the problem, all the assumptions from the initial exam instructions hold. In addition, assume we are in our standard New Keynesianeconomy, where the nominal wage, w, is fixed in the short run, but output prices, p, are flexible throughout.

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LRAS SRAS(wo) r LRAS LM(po) XX Po Y AD Y ro Y IS Y LRAS SRAS(wo) r LRAS LM(po) XX Po Y AD Y ro Y IS Y