Problem 2: Factor Price Adjustments [16 Points] This is not a mathematical question, but rather we want to see you use the figures in the model from class to show how the different curves will move around, and give explanations. Suppose that we begin in an economy that is both (ii in macroeconomic equilibrium, and {ii} at potential output (Y*) in other words there are no {current} output gaps. 6. Suppose that the costs of production for firms rise significantly over this period. What would we expect to happen to Y and p in the short-run? What type of output gap is created? Include a gure with AD, AS, and Y\" in your explanation. [3 points] Now suppose that the government is concerned about this output gap, and wants it to close. The local governing body is also very concerned about ination, and so are looking for a strategy that would allow them to both (i) close this output gap and {ii} reduce inflation (i.e. the price levels). 7. What action (if any) should you suggest the government can take to achieve both of these goals? Explain using a figure with AD, AS, and Y". [4 points] A big factor in the closing of these output gaps is the adjustment in factor prices, and many factor prices are often slow to adjust downwards. For example, for wages, this is referred to as downward wage rigidity. Now suppose that this economy is characterized by total downward factor price rigidity. This means the factor prices can never decrease and so will not adjust downwards over any period of time. 3. How would this change your answer to Question 7? What action (if any} should the government now take if they want to close this output gap? [3 points] Suppose that the government takes no action, but instead, that the economy experiences a large increase in autonomous investment due to a series of new oil wells and extraction technology being discovered. 9. Suppose that this increase in investment leads to a small change in prices and a large change in Y. What portion of the AS curve must we be on? [2 points] 10. What would happen to the output gap as a result of this large increase in autonomous investment? Explain using a figure with AD, AS, and Y\". [4 points]