Question

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Question 4 (25 points) - Chapter 10, 11 & 12 Suppose a destructive wave of wildfires sweeps through the country of Tinderbox, which for the simplicity of our economic modeling is assumed to be a closed economy. Unfortunately, the fire causes the death of many of the country's wild animals, but fortunately no humans die and no buildings or equipment is damaged by the fires. The widespread destruction causes both autonomous consumption and autonomous investment decline. Please refer (label) the initial long-run equilibrium as point A, the new short-run equilibrium as point B, and the new long-run equilibrium as point C. a) Suppose prior to the fires Tinderbox was in long-run equilibrium. Use one IS/LM diagram to show the short-run equilibrium impact of the fire induced shocks on the economy. Don't forget to label the new SR equilibrium as point B. In words describe the short-run impact to real output, the real interest rate, unemployment, the aggregate price level and the real money supply. (7 points) b) In your diagram from part A show the long-run impact of these fire induced shocks on the economy of Tinderbox. Don't forget to label the new LR equilibrium as point C. In words describe the long-run impact to real output, the real interest rate, unemployment, the aggregate price level and the real money supply. (8 points) c) In a new IS/LM model diagram show (again) the short-run impacts of the fire induced shocks. Now suppose central bank does not like the SR impact of the shocks and have decided to use monetary policy in order to push the level of cyclical unemployment to zero. In words describe the short-run impact to real output, the real interest rate, unemployment, the aggregate price level and the real money supply. In your diagram show the long-run impact of these fire induced shocks & the monetary policy response on the economy of Tinderbox. Don't forget to label the new LR equilibrium as point C. In words describe the long-run impact to real output, the real interest rate, unemployment, the aggregate price level and the real money supply. (10 points)

Answer 1

eiz vays e es @ we all know that the Is awere represents goods moveket equilibrium =ct It G The LM ewive represents money mack et equilibrium. M/P = L(017) The intersection of the Is and um cwere determines the level of national income. when one of these Coreve shifts of the short-run equilibrium of the economy changes. Shocks in the economy in The Is cnire . - :: idize Fire induced Shoeks to the economy o decline in spending a downward shift in the concemption fenation caused the contractionary Shift in the Is ewive. Decline in spending to the large drop in Investment in housing: 1M isi To as2 72 G XI It reduces labor demand, so lower employment and lower productivity reduce the output. The interest rates falls became tall in the income reduces demand for money. Investment ruses. because tou in interest rates supply of money is unchanged. OME

LRAS o am In the la with an In@rease equilibriu A It tar in 2 B - IS, - 152 a po ILRAS -SRAS - ADI AD2 IS shooks Shifts IS and AD cwere deft causing output falls, LRAS SRAS. N AD AD уу,

In the long run Inflation falls with an increase in output. Inerease im money supply causes equilibrium price level to rise. Р 2 SRAS, SRASO I Po A