Suppose that an economy is currently experiencing full employment, and inflation is only slightly higher than had been expected.

a. Draw and carefully label an AS/AD diagram that illustrates this case. Label the point representing the state of this economy E(a).

b. Suppose that investors’ confidence is actually only in the middle of an upswing. As investor confidence continues to rise, what happens to inflation and output? Add a new curve to your graph to illustrate this, as well as explaining in words. Label the point illustrating the new situation of the economy E(b).

c. What sort of tax policy might a government enact to try to counteract an excessive upswing in investor confidence? Assuming this policy is effective, illustrate on your graph the effect of this policy, labeling the result E(c).