Question

A country experiences severe storms which destroys its main resource, oil rigs. Assume that the countries economy was in long-run equilibrium before this shock happens.

1. Use the aggregate demand–aggregate supply model to illustrate graphically the short-run and long-run impact of this supply shock on output and prices. In other word how does the economy get back to long run? Be sure to label: i. the axes; ii. the curves; iii. the initial equilibrium values; iv. the direction the curves shift; and v. the terminal equilibrium values. State in words what happens to prices and output as a combined result of the supply shock, both in the short run and long run. What happens to unemployment rate in the short run and in the long run?

2. If the Central Bank of the country attempted to offset this deviation from the natural rate in the short run, should the money supply be increased or decreased? Show this action in the same graph and label the shifts. Which curve shifts? Does it shift to the right or left? What happens to output and prices as a result? What happens to unemployment rate? Explain.

Answer 1

a. A reduction in the supply of factor of production will reduce the level of Real GDP supplied in the economy at each price level and this will lead to leftward shift of the supply curve of the economy. In the diagram below, initial equilibrium in the economy occurs at point E1 where AD= ARAS= LRAS. Destruction of oil resources will lead to leftward shift of the SRAS curve to SRAS' and thus new short run equilibrium occurs at point E2 where price level has increased to P2 and the level of Real GDP has decreased to Y2. This causes recessionary gap and increases unemployment rate in the economy which reduces bargaining power of workers and this reduces wage rate which reduces cost of production in the economy and this shifts the SRAS' curve rightwards to SRAS and initla equilibrium at point E1 is restored where economy and output have returned to their intial level. and unemployment is at the natural level in the long run.

b.Since the economy is in recessionary gap because of destruction of oil resource, expansionary monetary policy needs to be followed by the Central bank to offset this deviation in the short run. This will increase money supply in the economy and thus aggregate demand curve will shift rightwards because of increase in investment expenditure caused by increase in money supply which reduced rate of interest in money market.Thus, AD curve will shift rightwards and at new equilibrium point E3 in the long run prices has increased to OP3 and output is back to the full employment level. The unemployment rate will also return to its natural level in the long run because of the above change.