Question 2:

Consider the AD-AS model discussed during the lectures. Assume that the aggregate demand curve is given by Y = 8 - 0.5, that the long run aggregate supply curve is given by Yp = 7, that the short run aggregate supply curve is given by=_expect + 0.3(Y - Yp), and that the monetary rule is given by r = 1 + 0.3.

1. a)What is the economic interpretation behind the aggregate demand curve? Why is it negatively sloped? If you consider point A=(,Y)=(3, 6.5) and point B=(,Y)=(5, 5.5), is monetary policy more expansionary in point A, in point B, or neither? Are you referring to the exogenous or to the endogenous stance of monetary policy?
2. (5 marks)
3. b)Suppose the economy is in equilibrium at the potential level of output, with inflation expectations equal to actual inflation, which equals 2%. A financial crisis hits the economy. Use the model to interpret what happens in the short run and in the long run if the central bank does not intervene exogenously with an expansionary monetary policy.
4. (8 marks)
5. c)According to the AD-AS model, what is more challenging for a central bank: to use active exogenous monetary policy to offset a financial shock, or to use active exogenous monetary policy to offset an exogenous increase in prices due to an oil price shock? Use the model to discuss each case separately. Can the central bank avoid a drop in output and a variation in the price level?

(12 marks)