What happens when bad aggregate demand shocks hit the economy? Consider the following graph. a. Before we get to the bad aggregate demand shock, let’s find out what the Solow growth rate is in this economy. Use the quantity theory to find your answer.
b. Because of a fall in the growth of the money supply, spending growth falls to 4% per year. Draw the immediate result on aggregate demand in the graph.
c. This fall in money growth lasts for many years. Eventually, in the long run, workers, business owners, and consumers all adjust their inflation expectations enough so that the economy returns to the Solow growth rate. Draw this new SRAS curve in the figure above. d. In the long run, after spending growth falls to 4% per year, what will the Solow growth rate be? What will inflation be?