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Liquidity preferences during the Covid-19 Recession. At the start of the Covid-19 recession, US consumers grew nervous about the economic outlook. As a consequence, they

Liquidity preferences during the Covid-19 Recession. At the start of the Covid-19 recession, US consumers grew nervous about the economic outlook. As a consequence, they held on to their money to a greater extent (i.e. their preference for liquidity increased).

  1. Within the AS/AD model, what are the short-run effects on inflation, real GDP and unemployment of this change in households' behavior? Please illustrate using graphs, assuming that the economy starts at the long-run equilibrium.
  2. Suppose, to start with, that policy makers do not respond to this change in households' behavior and that the classical dichotomy holds. What would be the long run effect on the price level and output? Please make sure to carefully explain how and why this happens.
  3. What, if anything, should the Fed do in response to the change in households' behavior? Please carefully describe how your preferred policy would be implemented, including its (poten- tial) effect on money supply, the Fed's balance sheet and the interest rate. Please also illustrate its impact on the economy in the AS/AD framework.

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