Assume the closed economy is on the full employment level of output.

(a) Show the situation on the correctly labeled aggregate demand and aggregate supply graph. Label the initial equilibrium with letter A. Is it a short-run or a long-run equilibrium? Will short run aggragete supply curve shift? Explain briefly.

(b) Suddenly the situation changes because of the decrease in business confidence. What type of shock occurs in the economy? Explain briefly. Show the change on your graph from point (a). Label the new equilibrium with letter B. Is it a short-run or a long-run equilibrium? Explain briefly.

(c) Suppose, following the classical scenario, policymakers do not intervene and wait when the economy returns to full employment by itself. Explain completely the mechanism of this adjustment. Show the change on the redrawn graph from point (b). Label the eventual equilibrium with letter C. Is it a short-run or a long-run equilibrium? Explain briefly.

(d) Now assume policymakers decide to conduct a stabilization policy. What type of policy will be more appropriate in the existing situation - fiscal or monetary? Explain your answer. What instrument of the chosen policy is the most flexible? Explain briefly. Show the result of the policy on the redrawn graph from point (b).