The US economy was hit two shocks at the onset of the 2008Global Financial crisis. First, it faced a negative supply shockdue to a doubling of the price of oil, large price increases inother commodities and the collapse of a domestic housing bubble.Soon after, a negative aggregate demand shock followed, as consumeroptimism dropped, while a reduction in credit supply in thefinancial sector caused firms to cut back on their investmentplans.
Using the AS/AD model and assuming that the economy isinitially at its long-run equilibrium (where output is equal toY*), show on a graph what happens in the short-run to inflation andoutput when the economy is hit by a negative demand shock such as adrop in consumer optimism or firm investment.
