. If you had your choice of a recession brought about by a demand shock or...

. If you had your choice of a recession brought about by a demand shock or a recession brought about by a supply shock which would you chose? Provide a complete justification of your choice.

Solutions

Expert Solution

Supply shock implies a decrease in the aggregate supply.

When aggregate supply decreases then this leads to fall in real GDP and pushes economy into recession. However, this also results in an increase in the price level.

The fall in real GDP leads to an increase in unemployment.

So, supply shock results in the higher price level and higher unemployment.

This means that not only the income level in the economy is decreasing but also the purchasing power is falling as well.

The combined impact of this would be the considerable decline in the standard of living in the country.

Demand shock implies a decrease in aggregate demand.

When aggregate demand decreases then this leads to fall in real GDP and pushes the economy into recession. However, the price level also decreases.

The fall in real GDP results in an increase in unemployment.

So, demand shock results in higher unemployment with lower price level.

This means that income level in the economy has decreased but purchasing power has increased.

This increase in the purchasing power somewhat neutralize the impact of the decrease in income due to demand shock.

So, the decrease in standard of living due to demand shock is of lesser magnitude than the decrease in the standard of living due to supply shock.

Thus,

We would chose a recession brought about by a demand shock as it is less severe.

Rahul Sunny answered 3 weeks ago

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