Scenario 2:

The economy of Chicagoland is currently producing $60 Million worth of goods and services (current real GDP). Full employment output for Chicagoland is $75 Million worth of goods and services (full employment real GDP). It has recently been experiencing unusual inflation as well. This has occurred due to a negative SRAS shock.

1.Use an AD/AS graph to show the macroeconomy of Chicagoland. Label the graph correctly.

a.First, show the long run equilibrium of Chicagoland using aggregate demand (AD) and short run aggregate supply (SRAS) at full employment. Label the full employment output Yf, and the corresponding price level, PL.

b.Then, use Y1 to represent the current rate of output and PL1 to represent the current price level.

2.Is the current rate of unemployment higher or lower than the natural rate of unemployment? How do you know?

3.Recall that the Federal reserve has a dual mandate of a steady rate of inflation and full employment. Which of these is the concern that the Fed has in this scenario?

4.If the Fed wants to address this issue, should it do something to lower interest rates or increase interest rates? What open market operation will the Fed need to conduct to change the interest rate?

5.Draw a graph of the money market. Use M1 to represent the current money supply and i1 to represent the current interest rate. Show the effect on the money market of the open market operation you specified in #4. Be sure to show the change in the money supply and the change in the interest rate as a result of the shift in the money supply.

6.Fill in the following "chain of events". Choose the appropriate change for each factor, in parenthesis and write it in the blank line.

Based on what you determined for #4, while conducting open market operations, what will the Fed do with bonds? (buy or sell) . This will cause money supply to do what? (increase or decrease). The change in the money supply will cause interest rates to do what? (increase or decrease) ____________. The change in the interest rates will cause investment spending to do what? (increase or decrease) __________. This change in investment spending will cause aggregate demand (AD) to do what? (increase or decrease) ___________. The resulting change in AD will cause inflation to (increase or decrease) ___________ and unemployment to (increase or decrease) ____________.