Two identical economies begin where actual output is equal to potential output. Economy A experiences a positive demand shock due to a fall in the risk premium, Economy B experiences an equivalent negative demand shock due to a rise in the risk premium.
Added by Montserrat T.
Step 1
Assume a standard New Keynesian setup with (i) an IS relation linking the output gap x (actual minus potential) to the real interest rate gap, (ii) a Phillips curve linking inflation π to the output gap, and (iii) a monetary policy rule (Taylor-type) for the Show more…
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Use the AS-AD model for this question. Assume the economy starts in equilibrium. Then, it suffers from a "negative demand shock" (assume consumer/business confidence suddenly declines significantly). A) What would be the immediate impact on the economy? B) According to a neoclassical economist, what would happen if the government keeps a "hands-off" approach? 2. Use the AS-AD model for this question. Assume the economy starts in equilibrium. Then, it suffers from a "positive demand shock" (assume consumer/business confidence suddenly improves significantly). A) What would be the immediate impact on the economy? B) According to a neoclassical economist, what would happen if the government keeps a "hands-off" approach?
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For each of the following, diagnose which type of economic shock has hit the economy: a. On your drive to campus, you hear a radio report describing how the recession appears to have ended and while output remains less than potential, the output gap has risen from -7% to -5%. The host is interviewing an economist who states, "The change in GDP isn't terribly surprising, as the Federal Reserve continues to cut the real interest rate." This scenario illustrates a demand shock. b. The latest inflation report indicates an unexpected uptick in inflation, even though output remains below potential. This scenario illustrates a cost-push shock. c. The real interest rate has been stable over the past few quarters, yet output has grown rapidly, leading to a more positive output gap. This scenario illustrates a supply shock.
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