1. a. As housing prices decrease, decreasing household wealth, it leads to a decrease in
borrowing to finance consumption decreasing aggregate demand, shifting AD curve to the left.
As consumption decreases, IS curve shifts to the left.
As demand decreases, firms cut productions and lay off workers. As N decreases, u increases.
Increase in u causes decreases in bargaining power and a decrease in nominal wages. As nominal
wages decreases, cost of production decreases, firms reduce prices. PS curve shifts down.
As P decreases, real money supply increases, LM curve shifts down. i decreases, thus investment
As output is less than natural level, P is less than Pe. After sometimes, price expectation adjusts
(Pe decreases). Wage therefore decreases, AS shifts to the right. As price falls, real money supply
increases, LM curve shifts down.
Final results: Y is the same, consumption is lower, investment is higher, interest rate is lower,
price is lower, unemployment is higher, and real wage is lower.
e. To keep interest rate at the original level, the Fed needs to decrease the money supply curve
and shift LM up to increase interest rate until it reaches the original interest rate.
However, as money supply decreases, aggregate demand decreases. Thus AD curve shifts even
more to the left, lowering both price and output.
Final results: Y decreases, investment is the same, interest rate is the same, consumption is lower,
price is lower, unemployment is higher and real wage is lower.
f. This policy is disadvantageous as it decreases output lower than the natural level. It’s best to
not interfere and let the economy self-adjust to its natural level of output.
2. a. As minimum wage is lower, workers with little skills who don’t ask for a high wage can join
the market, thus N is higher and unemployment decreases, WS shifts down.
As it is cheaper to hire workers, firms expand their production and reduce prices. AS curve shift