Question

In 2006 the United States is at full employment. Then, in 2007:

a. The real estate market collapses. Illustrate with a graph the effect of this event on the aggregate economy. Identify the result in the unemployment rate, real GDP and the price level.

b. Oil producing countries cut production. Illustrate with a graph the effect of this event on the aggregate economy. Identify the result in the unemployment rate, real GDP and the price level.

Answer 1

(a)

Collapse in real estate market will create the negative wealth effect.

Negative wealth effect leads to decrease in consumption by households.

Consumption is a component of aggregate demand.

So, decrease in consumption will lead to decrease in aggregate demand.

This will shift the AD curve to the left and will result in fall in price level and real GDP.

Fall in real GDP implies fall in production which in result will lead to job losses and will raise the unemployment rate.

Following is the required figure -

(b)

Cut in production of oil producing countries will reduce the supply of oil in the world market.

Given the demand for oil, this reduction in supply of oil will raise the price of oil.

Oil is an important input in production across industries.

So, increase in price of oil will increase the cost of production for firms. This will reduce their profit margin and will induce them to reduce production which in result will reduce the aggregate supply in short-run.

This will shift the SRAS curve to the left and will result in rise in price level and fall in real GDP.

Fall in real GDP implies fall in production which in result will lead to job losses and will raise the unemployment rate.

Following is the required figure -