Q1.

When real GDP declines during a recession, what typically happens to consumption,
investment, and the unemployment rate?
Recession is a time period when economy is not doing well. In the question, the statement of
“real GDP declines during a recession” already told you that income decreases during recession.
Therefore, the consumption and investment during recession tend to be low (the fall in C may
not be as drastic as I) since real GDP = C + I + G + NX. A fall in consumption and investment
will also cause unemployment rate to increase. This is because firms are producing less and so
cutting down their employees.

Q3. Why does the aggregate demand curve slope downward?

The reason why AD curve is downward sloping can be explained by the Quantity theory of
money: MV = PY. AD curve expresses the relationship between price level (P) and output (Y).
M changes if central bank implements new monetary policy. Hence, M is fixed if there is no new
policy implemented. V is fixed as economy’s spending behavior does not change in the short
run. Hence, if P increases, Y will fall to remain equals to MV. The reverse is true also.
Extra notes:
PY = total revenue / total expenditure; MV = total value of the transaction

Q5. Why is it easier for the Federal Reserve Bank (Central Bank in US) to deal with
demand shocks than with supply shocks?
It is easier to deal with demand shock than supply shock because:
a) When there is a demand shock, the economy only has one problem, either inflation or
unemployment [easier to solve the problem by implementing one policy to it]. But, when
there is a supply shock, the economy often has two problems, which are inflation and
unemployment happen at the same time. [have to decide which problem to solve first]
b) Monetary policy can affect / target demand side only, but fiscal policy can affect / target
demand and supply side.
c) Self-correction after supply shock may takes a long time or may not work if the
consumers and firms are pessimistic.

Extra notes:
 Demand shock can be positive (increase in AD = increase in income / can cause price to
increase) or negative (decrease in AD = income decrease / output decrease)
 Supply shock can be positive or negative. But most of the times, supply shock is a negative
shock – AS falls = price increase (because positive supply shock is desirable and not a
problem)
 When Central Bank implement any policies, the policy will tend to influence the demand
side, not supply side
P3. Let’s examine how the goals of the Fed influence its response to shocks. Suppose that in
scenario A the Fed cares only about keeping the price level stable and in scenario B the Fed
cares only about keeping output and employment at their natural levels. Explain how in
each scenario the Fed would respond to the following:
a. An exogenous increase in the price of oil [crude oil that runs machinery].
Oil is an essential resource / raw material for production. Thus, an increase in the oil
price will lead to an increase in the production cost.

When the price of oil increases, SRAS shifts upward to SRAS’. At SRAS’, new
equilibrium income moves fromy to y. Since income is lower than the full employment
income – y , there is unemployment.

Considering Fed’s objectives:

Scenario A: to keep price stable / constant
Solution is to allow the economy to correct itself but, this may take time. When no
policy is implemented by Fed, the AS will eventually fall because unemployment puts
downward pressure on prices, that is, makes price level fall.

That is, SRAS’ will eventually shift downward and reaches SRAS. Price will decrease
and income will rise at reachy.

Scenario B: to keep output and employment at their natural levels

Fed is not concerned about price, but only want to achieve full employment within a
short time. Solution is to implement expansionary monetary policy so that AD increases.
This solution can be faster than solution in scenario A but, this solution allows price
level to be permanently high.

Expansionary monetary policy causes an increase in money supply. Thus, interest rate
decrease, consumption and investment will then increase. This caused to AD shift to the
right.
Note: point A to B = when SRAS shift
point B to C = when monetary policy is implemented.

**When interest rate fall, slowly exchange rate will fall, the country’s currency depreciates