1. [5 participation points] Sort the following shocks into real shocks or aggregate demand shocks. Remember that "shocks" include both good and bad events. A fall in the price of oil A rise in consumer optimism A hurricane that destroys factories in Florida Good weather that creates a bumper crop of California oranges A rise in sales taxes Foreigners watch fewer U.S.-made movies Fear New inventions occur at a faster pace A faster money growth rate2. [5 participation points] Consider a negative real shock. What does it do to inflation? Does it rise, fall, or remain unchanged? What does a it do to spending growth? Does it rise, fall, or remain unchanged? Draw the AS-AD model graph and explain. 3.[5 participation points] After a monetary shock hits aggregate demand, which curve will shift to bring output growth back to the Solow growth rate: the short-run aggregate supply curve or the aggregate demand curve? (Hint: Which curve is more like a microeconomic story about prices adjusting in order to bring supply and demand into balance?) 4. [5 participation points] A country with a relatively small positive aggregate demand shock (a shift outward in the AD curve) may have a substantial economic boom, but sometimes countries that have massive increases in the AD curve (e.g., hyperinflation countries like Germany before World War ) don't seem to have massive economic booms. Why does a small AD increase sometimes raise GDP much more than a giant AD increase? 5. [5 participation points]Sticky wages can be thought of as a price ceiling or price floor in the labor market. Suppose the there is a negative AD shock and to return to the long-run growth rate wages and prices need to drop. However, wages are sticky. Shall we think of the long-run equilibrium wage as above or below the "sticky wage"? Does this generate an excess supply or excess demand of labor? Draw the market for labor assuming that labor supply is constant (or perfectly inelastic). Recall: Workers supply labor, and firms demand labor. 6. [5 participation points] Provide three reasons why prices and/or wages may be sticky in the short-run. Describe how sticky prices and/or wages are related to the shape of the SRAS curve. What happens when bad aggregate demand shocks hit the economy? Consider the following graph. LRAS Inflation rate () Worth Publishers SRAS (E[w] = 5%) 5% AD(M+7V = 9%) Solow Real GDP growth growth rate rate (a) Before we get to the bad aggregate demand shock, let's find out what the potential growth rate isin this economy. Use the quantity theory to find your answer. (b) Because of a fall in the growth of the money supply, spending growth falls to 4% per year. Draw the immediate result on aggregate demand in the graph. (c) This fall in money growth lasts for many years. Eventually, in the long run, workers, business owners, and consumers all adjust their inflation expectations enough so that the economy returns to the potential growth rate. Draw this new SRAS curve in the figure. (d) In the long run, after spending growth falls to 4% per year, what will the potential growth rate be? What will inflation be? Often, more than cne kind of shock hits the economy at once. When this happens, the different shocks could push inflation (or real growth) in different directions in the short run, leaving the final short-run result ambiguous. What is most likely to happen to inflation and real output growth in the following cases? Will they rise or fall, or can't you tell with the information given? Note that you will often (maybe always) be able to definitely know the answer for one but not the other. Draw the AS-AD graph and the shocks, and describe theirindividual and combined effects in the following cases: (a) A nation's scientists invent many new Internet search tools, raising current productivity and making investors optimistic about future inventions as well. (b) A government raises taxes and its economy experiences a year of excellent weather for growing crops. (c) Qil prices skyrocket and the central bank slows the rate of money growth. During the 1990s, the U.S. economy experienced a relatively quick transition to the electronic age of computers and the Internet. (a) Use the aggregate demand and supply model to show the effects of widespread computer and Internet usage on the economy if spending growth remains unchanged. (b) Suppose that velocity increases due to greater consumer confidence because of your findings in part a. First, does greater consumer confidence make sense? Why? (c) Second, how will this affect inflation and GDP growth in the long run