Supply and demand

  Consider the AD-AS model discussed during the lectures. Assume that the aggregate demand curve is given by Y=8-0.5 π, that the long run aggregate supply curve is given by Yp=7, that the short run aggregate supply curve is given by π = π_expect + 0.3(Y-Yp), and that the monetary rule is given by r=1+0.3 π. (a)What is the economic interpretation behind the aggregate demand curve? How does investment change when you move along the AD curve by considering combinations for which inflation decreases and output increases? (5 marks) (b)Suppose the economy is in equilibrium at the potential level of output, with inflation expectations equal to actual inflation, which equals 2%. A loss of consumer confidence hits the economy and leads to a sudden drop in consumption. Use the model to interpret what happens in the short run and in the long run if the central bank does not intervene exogenously with an expansionary monetary policy. (8 marks) (c)Is fiscal policy more useful, less useful or equally useful compared to monetary policy to avoid the loss of confidence generating a recession? Discuss and compare how fiscal and monetary policy can be separately used in response to the dynamics caused by the loss of consumer confidence. (12 marks)