Question

In this question we will reflect on the Australian fires from last year. A wide part of Australia has experienced severe fires in the last year, which made the economy much less productive and had severe impacts on business activities.

1. a) Explain why you could expect negative shifts in the aggregate demand curve following the fires. What would you expect are the drivers of this shift? Reflect on each of the components of the aggregate demand and comment on whether they are likely to change due to the fires. [6 marks]

2. b) Explain why you could expect negative shifts in the aggregate supply curve following the fires. What would you expect are the drivers of this shift? Reflect on each of the components of the aggregate supply and comment on whether they are likely to change due to the fires. [6 marks]

3. c) Show the shifts discussed in parts a) and b) graphically. You may assume an upward sloping AS curve for simplicity. Can you predict what happens to real GDP and the price level? [8 marks]

4. d) The fires in Australia can also be considered a decrease in the country’s stock of capital. You may use the Solow model to show what happens when capital decreases and what the model predicts for the new growth rate. Are these con- sequences likely to happen in practice? [10 marks]

Answer 1

a. the australian fires are expected to reduce consumer spending and lower rural exports. The fires are expected to have an effect on the prices of some goods and services, particularly in the affected regions too.

As a result, consumption is likely to fall, Net exports are likely to fall, fires also damaged wood which is an input for many production process, this is likely to reduce further investments in manufacturing.

AD= C+I+G+NX

As a result, AD will fall.

b. Since many companies use wood and other forest essentials as their input of production, the scarcity of these materials is likely to increase the cost of production for many firms. Reduced consumption would also mean lower demand, as a result firms would want to lower their production. Since prices are expected to fall post fires, firms are not willing to produce more and incur losses. As a result, AS will fall.

c.

real GDP falls and price level either remains same or increases

d. using solow model.

as capital falls, capital per worker also falls. and since output is a function of capital per worker, output per worker also falls.

steady state capital falls and the growth rate increases since poor countries are supposed to grow faster as per the model

This is likely to happen in practice as well because output has fallen due to loss of capital and and this would increase the growth rate by some although little amount