Question

A natural disaster strikes Wakanda and destroys a considerable amount of capital stock. Government officials believe this destruction will reduce national GDP and they should try to prevent this by increasing government spending. They hire you to make a recommendation.

a)With the aid of labour and output market diagrams, explain what would be the effects of the natural disaster on the economy. Is it reasonable that the government increases spending?

b)Illustrate, with the aid of diagrams again, what would be the effects of a temporary increase in government spending after the disaster strikes.

c)Based on your answer above, is there a more sensible justification for higher government spending?

d)Finally, what should the central bank do in response to the disaster if its goal is to stabilize the price level?

Answer 1

a)

Natural disaster would bring about destruction of resources and hence people purchasing power and demand get reduced as well. Fall in demand would cause fall in demand for labor and ultimately it will result into the fall in GDP of country.

Following is diagram:

Red lines have been used to show the impacts of natural disaster. Demand for labor falls, wage rate and output also fall owing to natural disaster.

People purchasing power fall due to loss of infrastructure and employment opportunities. Private investors are pessimistic to make investments in economic activities. Hence, it recommended that government must enter economic activities by increasing its expenditure.

b)

Following would be impacts of increase in government expenditure:

In above diagram, expenditure by the government will cause rightwards shift in Aggregate demand (AD), it increases output and employment opportunities. but side by side prices also rise up marginally.

c)

Natural disaster brings down the level of infrastructure. While private investors do not take up the activities of infrastructure developments. Thus, only government can take up such activities.

d)

Initially due to fall demand deflation may be experienced. Hence, Central Bank must decrease Federal Fund rate to increase more demand. But after rise of government expenditure, inflation may be experienced. thus, it should be countered by rise in the federal fund rate.