There were two major shocks to the U.S. economy in 2007, leading to the severe recession of 2007-2009. One shock was related to oil prices; the other was the slump in the housing market. This question analyzes the effect of these two shocks on GDP using the AD-AS framework.

a. Draw typical aggregate demand and short-run aggregate supply curves. Label the horizontal axis “Real GDP” and the vertical axis “Aggregate price level.” Label the equilibrium point £j, the equilibrium quantity ¥;, and equilibrium price P,.

b. Data taken from the Department of Energy indicate that the average price of crude oil in the world increased from $54.63 per barrel on January 5, 2007, to $92.93 on December 28, 2007. Would an increase in oil prices cause a demand shock or a supply shock? Redraw the diagram from part ato illustrate the effect of this shock by shifting the appropriate curve. . The Housing Price Index, published by the Office of Federal Housing Enterprise Oversight, calculates that U.S. home prices fell by an average of 3.0% in the 12 months between January 2007 and January 2008. Would the fall in home prices cause a supply shock or demand shock? Redraw the diagram from part b to illustrate the effect of this shock by shifting the appropriate curve. Label the new equilibrium point £3, the equilibrium quantity Y3, and equilibrium price P3.

d. Compare the equilibrium points E; and £; in your diagram for part

c. What was the effect of the two shocks on real GDP and the aggregate price level (increase, decrease, or indeterminate)?