Suppose the economy is initially in long-run equilibrium. Now, due to a decline in house prices, consumers reduce their consumption spending. (LO4)

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

b. Explain how your answer to part a affects the economy’s short-run equilibrium.

Use an AD-AS diagram to illustrate 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 government now must make regarding stabilization policy.