Question

Natural disasters: Suppose a large earthquake destroys many houses and buildings on the West Coast but fortunately results in little loss of life. Show how to think about this event using the IS curve. Explain how actual output, potential output, and short-run output are affected in the short run, and why.

Answer 1

Earthquake caused large amount of loss of capital but small loss of lives. This would lead to a fall in output in short run and fall of potential output in the short run because capital can't be increased in the short run and there has been loss of life,though very small. But in the lon run, as economy revives, capital increases, both long run output and potential output would increase.