a) SRAS curve is driven by three factors: (1) expectations of inflation, (2) output gaps, and (3) inflation shocks. If wages and prices are sticky, inflation adjusts slowly over time. The more flexible wages and prices are, the more rapidly they, and inflation, respond to deviations of output from potential output; that is, more flexible wages and prices imply that the value of y is higher, which in turn implies that the short-run aggregate supply curve is steeper. If wages and prices are completely flexible, theny becomes so large that the short-run aggregate supply curve becomes vertical and is identical to the long-run aggregate supply curve. Demand curve shifted left due to an autonomous tightening of monetary policy, a decrease in government purchases, an increase in taxes, a decrease in autonomous net exports, a decrease in autonomous consumption expenditure, a decrease in autonomous investment, and an increase in financial frictions b) The self-correcting mechanism occurs because the short-run aggregate supply curve shifts up or down to restore the economy to the long-run equilibrium at full employment (aggregate output at potential) over time. It is supposed to return to its potential output and the natural rate of unemployment over time. () Wages are inflexible, and there is a need for government policy to get us back to full employment. Inflation Rate, IT LRAS A ASB AS, A ADS ADA YP Aggregate Output, Y1) The graph below show the persistent negative GDP gap in the US following the Great Recession FRED ~ - Real Potential Gross Domestic Product - Real Gross Domestic Product, 3 Decimal 16,800 (Billions of Chained 2009 Dollars) 16,400 16,000 C 15,600 15,200 A P 14,800 B 14,400 14,000 13,600 2006 2008 2010 2012 2014 Draw a aggregate supply and aggregate demand graph depicting point A where we are in general equilibrium (the AD, SR.AS, and LRAS all intersect at point A where real GDP equals potential GDP. Label these three curves with a subscript A. (10 points for a correct and completely labeled graph) a) (5 points) We know that during the Great Recession the US experienced adverse shocks to the SRAS as well as to the AD curve. Please list separately the factors that caused the adverse shocks to SR.AS and AD respectively. Show how these shocks map to your AS-AD diagram and label as point B and the associated AS - AS curves with a subscript of B. b) (5 points) Now explain how the self correcting mechanism along with the effects of a persistent negative GDP gap is 'supposed to get the economy back to potential as in point C on the graphic above. Please label as point C on your diagram. c) c) (5 points) Now offer an explanation as to why the economy has not self corrected and thus, the negative GDP gap persists as in point D in the graphic above. Don't worry about labeling point D on your graph