Question

Q:Imagine a hurricane destroys all oil reneries in Texas. This cause a signicant
increase in the cost of doing business.
a) Draw a long-run equilibrium in the AS-AD model.
b) Draw the short-run equilibrium caused by the hurricane. How do output
and prices in the short-run equilibrium compare to the long-run? What can
you say about unemployment in the short-run? What will happen if the
Fed does not intervene?
c) Suppose the Fed decides to intervene. What would they do to get back to
potential GDP quickly? What are the long-run consequences of the Fed's
intervention?

Answer 1

A hurricane destroys all oil reneries in Texas. This cause a signicant increase in the cost of doing business.
a) The long-run equilibrium in the AS-AD model is shown below

b) The short-run equilibrium caused by the hurricane is shown below. With reduction in oil reneries cost of production is increased so production is reduced and so AS is shifted to the left.

Compared to long run, output is reduced and prices are increased in the short-run equilibrium compare to the long-run. With firms producing less, there will be higher unemployment in the short-run. In case the Fed does not conduct any expansion, the long run equilibrium will still be achived but the process will be painful. Economy will return to its full employment level when AS shifts rightwards when firms start producing more as they resurrect the reneries.

c) Suppose the Fed decides to intervene. To get back to potential GDP quickly, it would expand money supply so that AD shifts to the right. In the short run it wll raise price and real GDP. The long-run consequences of the Fed's intervention is higher inflation and a possible reduction in production when nominal wages are increased and employment is reduced.