Question

The consequences of climate change on the economy is a popular topic in the media. Suppose that a series of wildfires destroys crops in the western states at the same time a hurricane destroys refineries on the Gulf Coast. a) Using aggregate demand and supply analysis, explain how output and the inflation rate would be affected in the short and long runs. b) Show your answer graphically.

Answer 1

The aggregate supply curve can shift due to shocks to input goods or labor. For example, a wildfire could destroy a large number of agricultural crops—a shock that would shift the SRAS curve to the left since there would be fewer agricultural products available at any given price.

Oil is an input commodity. If a hurricane destroys the Gulf Coast, the quantity of oil supplied decreases, prices will shoot up causing Supply Curve to shift to the left.

Inflationary pressures will rise because of input prices that affects many or most firms across the economy. This situation can cause the aggregate supply curve to shift back to the left. In diagram B above, the shift of the SRAS curve to the left also increases the price level from  P0 at the original equilibrium E0, to a higher price level of P1 at the new equilibrium E1 . In effect, the rise in input prices ends up—after the final output is produced and sold—being passed along in the form of a higher price level for outputs.

Supply shocks are a little different from demand shocks. In this case, the long run impact will depend on whether those shocks are temporary or permanent. For example, suppose an increase in the price of oil leads to a negative supply shock (because an increase in input prices will cause SRAS to decrease). Here’s what will happen: As a result of the negative supply shock, output goes down, but inflation and unemployment go up. The increase in unemployment will theoretically lead to lower wages (because their is less competition for labor, so firms do not have to compete for workers with higher wages). SRAS increases once wages have adjusted, because a decrease in the price of a input to production will lead to an increase in SRAS. Output returns to the full employment output.

On the other hand, if a shock is permanent, there is an entirely different impact. Suppose that there is a permanent negative supply shock that makes the entire economy less productive, such as stricter regulations on production. Here’s what will happen: The capacity of the economy has decreased, so LRAS shifts to the left. Because such regulations make the cost of production higher, SRAS will also decrease until output has returned to the full employment output. In this case, output is permanently lower and the price level permanently higher.