Suppose that firms become very pessimistic about future business conditions and cut heavily on investment in capital equipment. [Label A, B, C for the initial, new short run and new long run equilibrium respectively]

a. Use an aggregate-demand/aggregate-supply model to show the short-run effect of this pessimism on the economy. Label the new levels of prices and real output. Explain in words why the aggregate quantity of output supplied changes. (Use the sticky wage theory in your explanation)

b. Now use the diagram from part (a) to show the new long-run equilibrium of the economy. Explain what happens to P and Y at the new long run equilibrium. Explain in words why the aggregate quantity of output demanded changes between the short run and the long run. [No policy involvement]

c. Redraw the diagram in part a) to show the pessimism of firms Point A and Point B. Now assume that Bank of Canada uses monetary policy to put the economy back to the initial long run equilibrium. What should it do to restore the equilibrium? Show on the diagram the effect of the policy and the new long run equilibrium. How the long equilibrium in this case compares to the long run equilibrium in b) above?