Question

Consider a negative short-run aggregate supply shock hitting the economy using the Aggregate supply/aggregate demand (AS/AD) model.

1. Give two examples of such a shock and carefully explain itsshort -run effects and the underlying reasoning (do NOT provide a diagram).

2. Assuming policymakers ignore this shock, explain step by step what happens in the economy in the longer-term (do NOT provide a diagram).

3. How should the central bank and/or the government respond to this shock? Carefully explain (do NOT provide a diagram).

4. Now consider a different shock. Researchers find a cure for COVID-19 and all other diseases, so all people get healthier, retire at a later age and die at the age of 120. How would you capture this situation in the AS/AD model (with the economy starting in long-run equilibrium)? Explain the intuition and show your arguments in a diagram. (Note that there may not be one correct answer; this question is trying to make you think outside the box and we are looking at the quality of your arguments).

Answer 1

A supply shock is an event that suddenly increase or decrease the supply of a commodity or goods in general.

In short run negative supply shock will shift the aggregate supply curve leftwards decreasing the output and increasing the price level. The situation will be rising price and falling output.

Here the examples of negative supply in short run aggregate supply can be drought, pandemic , increase in price of oil etc

When there is a heavy rain all the crops are washed off which result in decerease / shortage of crops which effect food supply of that country in general. Most of the people depend on crops such as rice and wheat grains etc when there is a shortage of supply in these items the demand increase supply decrease which leads to increase in price of the same.

Same goes for employment when the pandemic hit the world in general people faced the problem of unemployment .Companies were not able to perfrom as usual which lead to the company runing in loss which leads to cutting ofemployees . And the people gone as unemployed for so long . And still goes

Same is the case of rise in the price of oil . The petroleum oil or cooking oil or crude oil everything has its own high demand. When there is no enough supply that will lead to increse in price there also we face the problem of shock

If the policy makers ignore this problem the economy will suffer in all ways. The tax rate will be the same and people will suffer from that , they wont be able to take loans and intrest rate will play a major drawback. Usually when such unexpected crisis occurs policymakers will do everything in their hands to help people cop up with that situation by reducing tax rate by reducing the bank rate so that the banks can borrow money from RBI reduce lending rate provide different kinds of loans etc but when they ignore this problem the people will suffer alot from them . Thwy will be confused on what to do and what not to do to make the situation worse.  People will be lost without any guidance from policy makers

The government should respond by reducing taxes to the people, central banks should respond by providing loans to people and by reducing bank rate and lending rate . Should provide different kinds of loans to people so that they can save some money for the future. etc both should help and guide people fom this shock.

Now when researchers find cure for all the disease then it will be a positive shock In positive supply shock aggregate supply curve shift rightwards increasing the output and decreasing price level.

SARS will shift rightwrds output will increase and price will decrease

the graph will be as shown below