The Federal Reserve in 2008 faced a decrease in aggregate demand caused by the housing and financial crises and a decrease in short-run aggregate supply caused by rising commodity prices.

a. Starting from a long-run equilibrium, illustrate the effects of these two changes using both an aggregate-supply/aggregate-demand diagram and a Phillips-curve diagram. On both diagrams, label the initial long-run equilibrium as point A and the resulting short-run equilibrium as point B.

For each of the following variables, state whether it rises or falls or whether the impact is ambiguous: output, unemployment, the price level, the inflation rate.

b. Suppose the Fed responds quickly to these shocks and adjusts monetary policy to keep unemployment and output at their natural rates.

What action would it take? On the same set of graphs from part

a, show the results. Label the new equilibrium as point C.

c. Why might the Fed choose not to pursue the course of action described in part b?