Question 3 (AS-AD Model) (30 Points)

a) (3 points) Use interest rate effect to explain why Aggregate Demand (AD) curve is downward sloping.

b) (12 points) Suppose an economy is facing an inflationary gap (i.e., actual GDP is greater than normal GDP). (i) If the government did not intervene to close this gap, would the economy return to long-run macroeconomic equilibrium? Why? (ii) Instead of waiting for the long run, what are the fiscal and monetary polices that the policymakers can use to adjust the economy back to normal in the short run? And how?

c) (15 points) Suppose the economy is initially operating in the long-run equilibrium. A recent war led to a large increase in defense spending in US. Use four steps of AS-AD model to analyze its impact on the economy in the short run and in the long run. Illustrate your results in a diagram

Medium Run - AS- AD Model Summary P The price level SRAS "Short-Run The model P1 Aggregate determines the Supply" eq'm price level "Aggregate Demand" AD and eq'm output (real GDP). Y Real GDP, the quantity of output