Note: For answering all questions in this Quiz, keep in mind that a demand shock is a change in the equilibrium real GDP determined by the crossing points of IS and LM curves. A supply shock is a change in the production capacity. When the change is positive, the shock is called favorable. When the change is negative, the shock is called adverse. The magnitude of a demand shock is the absolute value of the change in equilibrium real GDP, and the magnitude of a supply shock is the absolute value of the change in the production capacity.

1. In 1997-1998, East Asian countries experienced a major financial crisis, which reduced their incomes significantly. This led to a major decline in the global demand for oil, which caused a sharp drop in oil prices in international markets in 1997-1998. This development acted as favorable supply shock for the European economy. The oil price decline also induced a favorable demand shock in Europe, though with a much smaller magnitude than the supply shock. If prior to 1997 the European economy had been in a long run equilibrium, then as a result of these shocks in 1997-1998, Europe must have experienced

a. a decrease in GDP growth rate and a rise in inflation rate.

b. an increase in GDP growth rate and a rise in inflation rate.

c. a decrease in GDP growth rate and a decline in inflation rate.

d. no change in GDP growth rate and a decline in inflation rate.

e. an increase in GDP growth rate and a decline in inflation rate.

f. an increase in GDP growth rate and no change in inflation rate.

2. In Question 1above, if the European central banks wanted to keep inflation the same as it had been before the 1997-1998 shock, they should have

a. increased their money supplies at faster rates than they did before 1997.

b. increased their money supplies at slower rates than they did before 1997.

c. increased their money supplies at the same rates as they did before 1997.

d. asked European governments to reduce their fiscal expenditures compared to the situation before 1997.