There were 2 major shocks to the US economy in 2007, which together lead to a...

There were 2 major shocks to the US economy in 2007, which together lead to a severe economic slowdown in 2008. One shock was related to oil prices; the other was related to the housing market. This question analyzes the effect of these two chocks on GDP using the AD/AS framework.

a) Draw typical AD and AS supply curves. Label the axis real GDP and aggregate price level. Label the equilibrium quantity Q1 and price P1. Data taken from the Department of Energy indicate that the average price of crude oil in the world increased from $54.63 per barrel on Jan. 5, 2007 to $92.93 on Dec. 28, 2007. Would an increase in oil prices cause a demand or a supply shock? Show in your diagram the effect of this shock by shifting the appropriate curve. What happens to GDP? Prices? Label the equilibrium quantity Q1 and price P1.

b) Again, draw typical AD and AS supply curves. The Housing Price index calculated that the average price of a US home fell by an average of 3.0% in the 12 months between Jan. 2007 and Jan. 2008. Would this increase cause a demand or a supply shock? Add to this second diagram another shift to illustrate the effect of this shock. What happens to GDP? Prices? Label the equilibrium quantity Q2 and price P2.

c)What is the net effect of the two shocks on GDP and prices –is there an increase, decrease or is the change indeterminate? Why?

Expert Solution

Answer :

(a) :- Follwing below graph represents an economy with no shocks and is stable with equilibrium price level P and GDP level Q. Now increase in price of oil will effect the supply curve. so it will be a supply shock. This negative supply shock will shift AS curve to its left which will result in decrease in equilibrium GDP (Q1<Q) and increase in equilibrium price level (P1>P).

(b) :- Decrease in price of housing was due to a demand shock i.e. decrease in demand of housing. Now this shock will have decrease in both price level and GDP.

(c) :- We know that GDP falls in both the shocks so GDP will definetly decrease. But prices increase in negative supply shock while decrease on negative demand shock. The overall effect of both the shocks depends upon the elasticities of demand and supply curve i.e. an inelastic curve is less responsive to change in price while an elastic curve is more. Here in my diagram, the decrease in price due to demand shock is less than increase in price due to supply shock so overall price level will show increase.

Rahul Sunny answered 2 years ago

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