Problem - Consider an economy in the United States, starting from the long-run equilibrium denoted as the point A. Use an aggregate demand and aggregate supply (AD-AS) diagram to show that the economy is in the long-run equilibrium. (Please label variables clearly)
1. If the U.S. currency becomes stronger (the value of a dollar increases), there is a change in international variables (X-M). How does this situation affect the AD-AS diagram? What will happen to the equilibrium price level and real GDP in the short run? Is the economy experiencing an inflationary gap or a recessionary gap? Explain your answer. (Please write the new equilibrium point denoted as the point B)
2. From your answer in part (a), assume that neither the Fed nor the government imposes any policies to simulate the economy. According to the concept of self- correction, in the long run, what will happen in the economy? How is the economy being improved? Explain it in words and graphically, using AD-AS diagram? (Please write the new equilibrium point denoted as the point C)
c. From your answer in part (a), during the business cycle, how does the Fed use monetary policy tools to overcome the problems faced by the economy, using money market diagram, and AD-AS diagram? (Please write the new equilibrium point denoted as the point C)
d. From your answer in part (a), how does government use fiscal policy to maintain the level of full employment, using Aggregate Expenditure (AE) model and AD-AS model? How much does real GDP change if government spends $20 million and marginal propensity to consume is 90%?