Part 2: The dynamics after a shock
Consider an economy with all parameters v, b, m strictly positive. In the following questions, you are asked
to depict the transition dynamics into the AS/AD diagram. Devote a whole page to this diagram so that
you can plot with enough detail. Make sure that you accurately represent the shifts of the curves and the
resulting equilibria.
Question 2.6 The economy is in steady state in period 0. Depict the aggregate demand and aggregate
supply curve in period 0, denoted $AD_0$ and $AS_0$, respectively. Label axes and the steady state level of
inflation and output gap. Denote the equilibrium in the economy as $E_0$.
Question 2.7 This economy experiences an adverse demand shock in period 1, for example because of a
decline in foreign demand for U.S. goods. Describe how is this shock represented in the equations for
aggregate demand and aggregate supply [one sentence].
Then depict this shock in the AS/AD diagram by appropriately shifting the AS and/or AD curves. Denote
the new curves $AD_1$ and $AS_1$, the equilibrium in period 1 as $E_1$, and the equilibrium output gap $Y_1$ and
equilibrium inflation $\pi_1$ in period 1.
Question 2.8 In period 2, the adverse shock to aggregate demand continues with the same magnitude.
Depict the new curves $AD_2$ and $AS_2$, the equilibrium in period 2 denoted $E_2$, and the equilibrium output
gap $Y_2$ and equilibrium inflation $\pi_2$.
Question 2.9 In period 3, the adverse shock reverts back to zero and stays at zero thereafter. Depict the
new curves $AD_3$ and $AS_3$, the equilibrium in period 2 denoted $E_3$, and the equilibrium output gap $Y_3$ and
equilibrium inflation $\pi_3$.
Question 2.10 Plot the trajectories for output gap and inflation (each into a separate graph with time on
the horizontal axis, large enough so that you can latter plot additional lines), starting in period 0, until
period 10. Data for periods 1, 2, 3 should be inferred from the AS/AD diagram that you just plotted. The
remaining periods can be sketched based on your knowledge about the convergence of the economy to
the steady state, assuming that the economy is not hit by any additional shocks.
Denote these trajectories for output gap and inflation as Case A.