xample b/c of a cost shock such as an increase in the cost of oil) and Aggregate Demand stays the same (or decreases). Prices increase while output decre Homework #3 Solutions 1. Stagflation—occurs when the overall price level rises rapidly (inflation) during periods of recession or high and persistent unemployment (stagnation). Fed increases Ms (money supply): If Ms increases, then interest rates fall which encourages investment which produces an increase in Y for a given P; hence, the AD curve will shift right. Inflation continues. Government Lowers Taxes: Lower taxes causes an increase in Aggregate Expenditures which increases Y for a given P; again the AD curve will shift right. Inflation continues. 2. a. (1) Fed “tightening monetary policy”: Ms decreased causing interest rates (r) to increase. This causes planned I to decrease which causes output to decrease. (2) “cut in individual income tax”: taxes decrease which increases AE which cause equilibrium Y to increase which causes the transaction demand for money to increase, causing r to increase. Thus, these two policies were working in opposite directions with regards to Y (i.e.
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