This question attempts to clarify the mechanisms by which an increase in uncertainty about the future economy can affect the economy today, using the AD/AS model.

a) Assume that the US economy begins in a situation in which actual GDP (Y) is equal to the potential level of GDP (YP). Illustrate this situation in the AD/AS diagram, labeling the initial equilibrium point A. [Hint: recall that actual output is always on the AD and the AS curves].

b) Consider now the IS curve diagram. Suppose that an increase in uncertainty about the future economy causes firms to want to spend less on investment goods (e.g. capital spending) at any given interest rate. How would this shift the IS curve? Explain, using the IS curve diagram.

c) Consider now the AD/AS curve diagram. How would the increase in uncertainty about the future economy shift the AD curve? What would be the effect of the change in b) on the short-run equilibrium levels of output and inflation? Explain the intuition and draw the short-run equilibrium point B in the AD/AS diagram.