In our analysis of Ch.10, we studied the aggregate demand (AD) and aggregate supply (AS) model in the context of recessions, expansions and supply shocks on economic activity. In addition, in Ch.12, we discussed the role of monetary policy on economic activity. As a result, the different type of 'shocks' that affect economic activity bare consequences on the level of inflation and output. Central banks, such as the RBA, can simultaneously pursue "stabilising prices" (i.e., maintaining a targeted level of inflation) and "stabilising economic activity" (i.e., economic activity remaining at its potential level). However, not all shocks to the economy are equal. In response to this, economists/policymakers can either achieve price stability or economic stability, but not both. This trade-off ultimately poses a dilemma for central banks with dual mandates such as price stability and economic activity. On the other hand, New-Keynesian theory suggests that there is no trade-off between price stability and maintaining economic activity - something called the "divine coincidence".

Question: While evidence shows that the Global Financial Crisis (GFC) impacted firms (small to large), it is generally accepted (and shown by empirical studies) that the GFC predominantly impacted on households/consumer spending (i.e., on aggregate demand). Assume this is the case. Also assume that there is no fiscal policy response from the government. a. Explain and illustrate the short-run effect of the GFC on macroeconomic equilibrium using the AD-AS model. [0.5 marks] b. Explain and illustrate the adjustment process to back to long-run equilibrium based on the following i. Self-correcting mechanism (i.e., with no policy response). [1 mark] ii. Active stabilisation response (i.e., with policy response). [1.5 marks]