1.6. What happens when bad aggregate demand shocks hit the economy? Consider the following graph.

Inflation rate

(1r)

5%

a. Suppose labor demand falls, shifting to the left, as in the figure above. What does the short-run supply curve for labor look like if workers refuse to take pay cuts even if it means losing their jobs (we can call this the

"take this job and shove it" strategy after the famous country and western song). Indicate your answer by drawing a new line on the figure above, labeling it "short-run labor supply." You only need to focus on the area

~ ~

AD(M+ v = 9%)

Real GOP Solow growth rate growth rate

a. Before we get to the bad aggregate demand shock, let's find out what the Solow growth rate is in this economy. Use the quantity theory to find your answer.

to the left of Q*.

b. Recalling your basic supply-and-demand model, does this fall in labor demand then create a "surplus" of workers or a "shortage"

of workers?

b. Because of a fall in the growth of the money supply, spending growth falls to 4% per year.

Draw the immediate result on aggregate de mand in the graph above.

c. This fall in money growth lasts for many years. Eventually, in the long run, workers, Business Fluctuations: Aggregate Demand and Supply • CHAPTER 1 3 • 301 business owners, and consumers all adjust their inflation expectations enough so that the economy returns to the Solow growth rate. Draw this new SRAS curve in the figure above.

d. In the long run, after spending growth falls to 4% per year, what will the Solow growth rate be? What will inflation be?