PROBLEM 2

a.Explain how the "wealth effect" causes the Aggregate Demand curve to be downward sloping.

b.Explain how "sticky nominal wages" cause the Short-Run Aggregate Supply curve to be upward sloping.

c.The table below lists a number of economic events. For each event, indicate

i.whether it will shift the AD curve to the right (by entering "R"), to the left (by entering "L"), or not at all (by leaving it blank);

ii.whether it will shift the Short-Run AS curve to the right (by entering "R"), to the left (by entering "L"), or not at all (by leaving it blank)

iii.what will happen to equilibrium Real GDP as a result of the shifts (enter "+" for an increase, "-" for a decrease or "?" if the result is ambiguous);

iv.what will happen to the equilibrium Aggregate Price Level as a result of the shifts (enter "+" for an increase, "-" for a decrease or "?" if the result is ambiguous)

The first entry is filled in for you.[FILL IN THE REMAINING ROWS, AS INSTRUCTED ABOVE]

Events

AD

Shift

S-R AS

Shift

Change in

Eq. GDP

Change in

Eq. Price Level

An increase in consumer optimism causes a rise in consumption

R

+

+

A nationwide, prolonged internet outage severely decreases worker productivity

A sharp rise in the stock market increases consumer wealth

The price of oil sharply decreases AND businesses decrease investment due to pessimism about the future

A sharp rise in health insurance premiums requires employers to increase their workers' overall compensation

d.Is the economy depicted in Figure 1 (on p. 6) experiencing an inflationary gap, a recessionary gap, or neither? Explain your answer.

e.Assume that the government takes no action in response to the situation depicted in Figure 1. How will the economy adjust over time so that short-run equilibrium real GDP eventually equals potential real GDP? (Note: For full credit you must NOT ONLY indicate which curves will shift and in which direction, BUT ALSO what willcausethe curves to shift.)