In this assessment task, you must utilise the IS-LM and AD-AS models to illustrate short-run economic fluctuations and the movement to long-run equilibrium. Assume a large open economy with a floating exchange rate. Ensure your graphs align with the appropriate IS-LM (upwards-sloping LM curve) and AD-AS modelling frameworks. Always draw the IS-LM diagram above the AD-AS diagram and show the connection between both graphs. You must complete this part of the assessment task for your allocated policy mix, with the fiscal and monetary policy mix allocation 我分配到的财政和货币政策组合是 a) Negative demand shock b) No fiscal or monetary policy c) Adjustment of inflation expectations (if needed） Important hints: • Use different colors for a) b) c). • First, explain what happens to GDP, interest rates, unemployment, and inflation as a result of the shock in a) . Show it in the diagrams. • Second, explain if the policy in b) makes sense and how it affects GDP, interest rates, unemployment, and inflation. Show it in the diagrams. For students with “No fiscal or monetary policy”: explain which economic mechanism will bring the economy back to potential GDP over time. • Third, explain if the inflation rate in your graph is consistent with inflation expectations. Show how your graph is changing when inflation expectations adjust to the situation in your graph.

First, let's start with a) Negative demand shock. In the IS-LM model, a negative demand shock is represented by a leftward shift of the IS curve. This is because a negative demand shock reduces the demand for goods and services, which in turn reduces the level of income and output (GDP). As the IS curve shifts left, the equilibrium level of income and the interest rate both decrease. This is shown in the IS-LM diagram by a movement along the LM curve to a lower level of income and a lower interest rate.

In the AD-AS model, a negative demand shock is represented by a leftward shift of the AD curve. This is because a decrease in demand leads to a decrease in the price level (inflation), and a decrease in the level of output (GDP). As the AD curve shifts left, the equilibrium level of output decreases and the price level decreases. This is shown in the AD-AS diagram by a movement along the AS curve to a lower level of output and a lower price level.

The decrease in output (GDP) leads to an increase in unemployment, as firms cut back on production and lay off workers. The decrease in the price level (inflation) is a result of the decrease in demand.

Second, let's consider b) No fiscal or monetary policy. In this case, there is no policy response to the negative demand shock. The economy is left to adjust on its own. In the IS-LM model, this means that the economy will eventually return to its potential output level as the IS curve shifts back to the right. This is due to the self-correcting mechanism of the economy, where a decrease in income leads to a decrease in interest rates, which stimulates investment and shifts the IS curve back to the right.

In the AD-AS model, the economy also returns to its potential output level as the AD curve shifts back to the right. This is due to the self-correcting mechanism of the economy, where a decrease in the price level (inflation) increases the real value of money, which stimulates spending and shifts the AD curve back to the right.

Finally, let's consider c) Adjustment of inflation expectations. If the actual inflation rate is lower than expected, people will adjust their expectations downwards. This will shift the AS curve to the right, as firms are willing to produce more at each price level. This will lead to a further decrease in the price level (inflation) and an increase in output (GDP), moving the economy closer to its potential output level.

In conclusion, a negative demand shock leads to a decrease in GDP, interest rates, and inflation, and an increase in unemployment. Without any fiscal or monetary policy response, the economy will eventually return to its potential output level due to the self-correcting mechanism of the economy. The adjustment of inflation expectations can help to speed up this process.