Suppose that the economy is in a long-run equilibrium.

a. Use a diagram to illustrate the state of the economy. Be sure to show AD, short-run AS and long-run AS.

b. Now suppose that a financial crisis causes AD to fall.

Use your diagram to show what happens to output and the price level in the short run. What happens to the unemployment rate?

c. Use the sticky wage theory of AS to explain what will happen to output and the price level in the long run (assuming there is no change in policy).

What role does the expected price level play in this adjustment? Be sure to illustrate your analysis with a graph.