a) Suppose the central bank's short-run response to any change in the economy is to change the

money supply to maintain the existing real interest rate. What would happen to money supply if

there were a reduction in government purchases? Given the Fed's policy, what would happen in the

very short run (before general equilibrium is restored) to output and the real interest rate? What must

happen to the LM curve and the price level to restore general equilibrium?

b) Suppose you were a forecaster of the real wage rate, employment, output, the real interest rate,

consumption, investment, and the price level. A shock hits the economy, which you think is a

temporary adverse supply shock.

(a) What are your forecasts for each of the variables listed above (rise, fall, and no change)?

(b) What if the shock was really due to people's reduced expectations about their future income.

Which variables did you forecast correctly, and which did you forecast incorrectly?