Question

On 26 February, Hong Kong’s Financial Secretary Paul Chan announced that all permanent residents in Hong Kong will receive a HK$10,000 from the HKSAR government. This policy will cost the HKSAR government roughly HK$71 billion and it is aimed at tackling the worse economic downturn that the city has experienced in the last 10 years.

a. Briefly explain why this policy can increase equilibrium output in the short run.

b. An economist argues that if the HKSAR government spends HK$71 billion on goods and services instead of giving each Hong Kong resident a HK$10,000, the policy effect on output would be larger. Briefly discuss the economic rationale behind this economist’s argument.

Answer 1

A. Giving people money in their hand, will increase aggregate demand and it will shift right.

Positive Demand Shock

This economy was initially at long-run equilibrium, so its current output Y1 was equal to its full employment output Yf. As the result of an increase in one of the components of AD, the entire curve will increase (shift to the right). At the old price level, AD would exceed SRAS. This excess demand puts upward pressure on the price level until the economy assumes a new short-run equilibrium at a higher price level PL2​ and higher output Y2​. Because output has increased, the unemployment rate has decreased.

Long run self adjustment to Positive AD Shock

This economy is initially in long-run equilibrium. Its current output Y1​ is the same as its full-employment output Yf​

Then, one of the components of AD increases, as shown by shift (1). As a result, output and the price level increase.

An increase in the price level will drive up input prices and expectations about inflation, which leads to the decrease in SRAS shown by shift (2). In the long run, the price level has increased, but the new output Y3​ is once again equal to the full employment output Yf​

B. The economist argument of the policy effect on output would be larger is based on Positive Supply shock

This economy was initially at long-run equilibrium, and its current output Y1​ was equal to its full employment output Yf​. Something has changed in the economy making output cheaper for producers, such as a decrease in the cost of labor. At the old price level, SRAS would exceed AD. This surplus output puts downward pressure on the price level until the economy assumes a new short-run equilibrium at a lower price level PL2​and higher output Y2​. Because output has increased, the unemployment rate has decreased.

Shifts in SRAS are caused by things that impact the ability to produce goods and services in the short run. The most common factor that affects SRAS is an economy-wide change in factor prices. Some things that impact an economy’s ability to produce are so profound that they have not just a short-run impact, but a long-run impact, which means both the SRAS and LRAS will shift. For example, if more resources become available (like an entirely new form of energy is discovered), then this would shift the LRAS curve to the right. We will develop this idea more in a future lesson, however. For now, focus on the immediate impact a change in the cost of production has on SRAS alone.

Long run Impact of Supply Shock

Supply shocks are a little different from demand shocks. In this case, the long run impact will depend on whether those shocks are temporary or permanent. For example, suppose an increase in the price of oil leads to a negative supply shock (because an increase in input prices will cause SRAS to decrease). Here’s what will happen: As a result of the negative supply shock, output goes down, but inflation and unemployment go up. The increase in unemployment will theoretically lead to lower wages (because their is less competition for labor, so firms do not have to compete for workers with higher wages). SRAS increases once wages have adjusted, because a decrease in the price of a input to production will lead to an increase in SRAS. Output returns to the full employment output.

On the other hand, if a shock is permanent, there is an entirely different impact. Suppose that there is a permanent negative supply shock that makes the entire economy less productive, such as stricter regulations on production. Here’s what will happen: The capacity of the economy has decreased, so LRAS shifts to the left. Because such regulations make the cost of production higher, SRAS will also decrease until output has returned to the full employment output. In this case, output is permanently lower and the price level permanently higher.