Question 2:

a. Draw the aggregate supply and aggregate demand model to show the initial long run equilibrium in the real output market. Label the equilibrium point A. Now suppose that a recession happened in U.S. Show the impact of this on Canadian economy in the short run. Label the new short run equilibrium point B. Give a clear explanation about the change in quantity of output produced (use sticky wage explanation)

b.Following from a), show and explain clearly how the economy will reach the long run equilibrium when there is no policy involvement and the economy has to return back to natural level of output on its own. Call the new equilibrium point C. What happens to the price level and output?

c.Redraw the diagram from part a). Now suppose that the government wants to use the fiscal policy to bring the economy back to the natural level. What should it do to bring the economy back? What happens to the price level and the output in this case? How the long run equilibrium is different from part b)? What is the benefit of using the policy?