Suppose the economy is initially in long-run equilibrium. Due to a decline in house prices, suppose that consumers reduce their consumption spending. (LO1)

a. Explain how the decline in consumer spending affects the AD curve.

b. If the Fed does not change its monetary policy rule, how will the Fed react to the decline in consumer spending? Use an AD-AS diagram to illustrate and explain your answer.

c. Now, in addition to the decline in consumer spending, suppose that the economy experiences an adverse inflation shock.

i . Explain how the adverse inflation shock affects the AS curve.

ii. Discuss, using AD-AS diagrams, what choices the Fed now must make regarding monetary policy. ( Hint : Think about whether or not it should tighten monetary policy.)