Section 15 (A-I)

Thorin III Stonehelm, son of Dain, became King of the Lonely Mountain after his father's fall in the War of the Ring. The dwarves of his kingdom were busy and prosperous producing the weapons, armor and jewelry for which they were famous and which the inhabitants of Middle Earth were demanding now that there was peace. But Thorin III Stonehelm began to notice that prices were rising in his kingdom and he went to consult with King Bard II of Dale (son of Brand) to see why this was happening.

The lands opened wide about him, filled with the waters of the river which broke up and wandered in a hundred winding courses, or halted in marshes and pools dotted with isles on every side; but still a strong water flowed on steadily through the mist. And far away, its dark head in a torn cloud, there loomed the Mountain! Its nearest neighbours to the North-East and the tumbled land

that joined it to them could not be seen. All alone it rose and looked across the marshes to the forest.

The Lonely Mountain!

A) Draw (in the AD/AS model) and explain what happens to aggregate demand in the short run. What happens to the price level, unemployment and real GDP in the short run? Is there an inflationary or recessionary gap?

b) Draw (in the AD/AS model) and explain what happens to the Lonely Mountain economy on its own in the long run as a result of a) if no policy response occurs. What happens to the price level, unemployment and real GDP in the long run? Include all the dynamics. Is this inflation? Explain why or why not. If so, what is it called?

c) Draw (in the AD/AS model) and explain what happens to the Lonely Mountain economy in the long run as a result of a) if the Council (Fed) immediately applies monetary policy and contracts the money supply rather than wait for the economy to self-correct like in b). What happens to the price level, unemployment and real GDP in the long run? What is the final difference in the result of the monetary policy and the results in b)?

d) The Federal Council of Elrond (Fed) gets on a roll and increases the money supply each year for 3 years. Draw (in the AD/AS model) and explain the long-run effect of these increases on the economy of the Lonely Mountain. What happens to the price level, unemployment and real GDP in the short run and in the long run? What is the end result of these continued increases? Is there inflation? Explain why or why not. If so, what is it called?

The economy of the Lonely Mountain is dependent on iron for its armor and weapon manufacturing. A pack of Orcs fleeing the destruction before the gates of Barad-Dur make their way to the Iron Hills where the dwarves mine ore and force battle. The Attack on the Dwarves' mines causes a temporary supply shock to the economy of Middle Earth due to the reduction of raw materials.

e) Draw (in the AD/AS model) and explain the short-run effect of the supply shock on economy of the Lonely Mountain. What happens to the price level, unemployment and real GDP in the short run? Is there an inflationary or recessionary gap?

f) Draw (in the AD/AS model) and explain what happens to the Lonely Mountain economy on its own in the long run as a result of e) if no policy response occurs. What happens to the price level, unemployment and real GDP in the long run? Include all the dynamics. Is there inflation? Explain why or why not. If so, what is it called?

g) Draw (in the AD/AS model) and explain what happens to the Lonely Mountain economy in the long run as a result of e) if the attacks continually re-occur and the Council (Fed) applies expansionary monetary policy and increases the money supply one time rather than wait for the economy to self-correct like in f). What happens to the price level, unemployment and real GDP in the long run? Is there inflation? Explain why or why not. If so, what is it called? What is the final difference in the result of the monetary policy and the results in f)?

h) Draw what happens in the AD/AS model when an increase in the money supply is correctly anticipated. Is there an increase in output or change in unemployment? Explain why or why not. What are two methods by which people form expectations?

i)If inflation was actually higher than anticipated, what would be the short-run result for output and unemployment? If inflation was actually lower than anticipated, what would be the short-run result for output and unemployment? Graph both and indicate any gaps.