2. *A decline in foreign demand for US goods. Suppose that European and Japanese economies succumb to a recession and reduce their demand for US goods for several years. Let t = 1 denote the period when this shock hits. Assume that demand goes back to normal starting in period 9. Assume that the economy was in steady state before the shock hit. In this question, you will use the AS/AD framework to explain the macroeconomic consequences of this shock.

(a) What happens on the first period when the shock hits (i.e., on period 1) ? Explain which curve shifts and why. Show the change in short-run output and inflation in your diagram, using 1 and Y 1 to label the new equilibrium inflation rate and short-run output.

(b) What happens in period 2 with short-run output and inflation? Is any curve shifting this period? If so, why? Re-draw the AS/AD diagram from the previous item and add any curves thay may have shifted in period 2. Carefully label all points and relevant intercepts in the axis.

(c) What happens as time goes by while the negative demand shock lasts? Assume that the demand shock lasts enough so that the economy arrives to a point where inflation is stable. Illustrate this point (label it as C) in an AS/AD diagram. Find the exact value of inflation in this situation (i.e., C ) as a function of parameters.

(d) In period 9, the negative demand shock subsides (i.e., there is no longer a recession in Europe and Japan). What happens with inflation and short-run output in this period?

(e) Starting in period 10, and as time goes by, what happens with short-run output and inflation? Illustrate the dynamics of the economy with an AS/AD diagram.