Assume that the economy starts at the natural level of output. Now suppose there is a decline in

business confidence, so that investment demand falls for any interest rate.

a. In an AS-AD diagram, show what happens to output and the price level in the short run

and the medium run.

b. What happens to the unemployment rate in the short run? in the medium run?

Suppose that the Federal Reserve decides to respond immediately to the decline in business

confidence in the short run. In particular, suppose that the Fed wants to prevent the

unemployment rate from changing in the short run after the decline in business confidence.

c. What should the Fed do? Show how the Fed's action, combined with the decline in

business confidence, affects the AS-AD diagram in the short run and the medium run.

d. How do short-run output and the short-run price level compare to your answers from part

(a)?

e. How do the short-run and medium-run unemployment rates compare to your answers

from part (b)?