a. Consider a positive AD shock (i.e. increase in the AD curve) hitting the economy. First, give examples of such a shock. Second, use the AS/AD diagram to show both the short-run and long- run effects of the shock. Third, explain step by step the adjustment after the shock, i.e. both the short run deviation from LRAS and the self-correction back to LRAS assuming policymakers do NOT respond to the shock.
b. Now re-consider part a., assuming that the policymakers (monetary or fiscal) respond optimally to the shock in order to stabilize the economy. Hint: recall from the lectures that they are trying to achieve as little changes in P and Y as possible. In a separate diagram, show how the outcomes would differ, and discuss it carefully. Can the policies reduce fluctuations of the economy compared to part a?
c. What type of shocks do you think are easier to stabilize: AD or SRAS? Positive shocks (that increase output) or negative shocks (that decrease output)? Why?
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