Question

3. For the following changes in an economy, explain (both text and graphs) using an LRAS- AD-SRAS framework, whether short-run aggregate supply or long-run aggregate supply will be affected. Also, indicate the direction of the change in short and long run, effect on price, unemployment and real GDP. [Assume the economy is at the long run equilibrium & write a new graph for each question]. [4.0] a. An unfavorable supply shock (loss due to hurricane or fire). b. The stock of the capital in the economy increases. c. An increase in the labor force. d. A decrease in the price level.

Answer 1

Initially the economy is in the equilibrium where aggregate demand, short run aggregate supply and long run aggregate supply are equal to each other. Now there is some changes take place due to that short run aggregate supply and long run aggregate supply shift from their places.

A) An unfavorable supply shock- Due to hurricane and fire, there is negative supply shock occur. It is temporally and due to it, firms will incur losses and reduce the supply and short run supply curve will shift leftwards. Due to leftward shift of supply curve price will increase from P to P1 and real GDP will reduce from Q to Q1 and employment will fall.

B) The stock of the capital in the economy increases.- Long run supply curve shift due to increase or decrease in capital and as the capital increases LRAS will shift rightwards because of increase in potential output and due to that prices will reduce and real GDP will increase and employment will increase.

3)An increase in the labor force.- Long run supply curve shift due to increase or decrease in labor force and as the labor force increases LRAS will shift rightwards because of increase in potential output and due to that prices will reduce and real GDP will increase and employment will increase.

d. A decrease in the price level.- Due to decrease in price level , there is negative supply shock occur. It is temporally and due to it, firms will incur losses and reduce the supply and short run supply curve will shift leftwards. Due to leftward shift of supply curve price will increase from P to P1 and real GDP will reduce from Q to Q1 and employment will fall.