Question

An economy in its long-run equilibrium (i.e., output is at its natural level). Draw a graph of the AS curve in the short run and the AD curve and, in the graph, denote by A the pair ( Y,P) where the economy finds itself. The economy is now hit by a shock: the power of unions becomes temporarily very high so the cost of hiring workers increases substantially.

(a) Is this a supply shock or a demand shock? Explain.

(b) How will this (temporary) shock affect the economy? Draw a graph of the AS curve in the short run and the AD curve and show how this shock moves the economy away from its long-run level of output.

(c) Can monetary or fiscal policy bring back the economy to point A? Explain.

Answer 1

We have an economy in its long-run equilibrium at A where price is P and output level is L.The economy is now hit by a shock where the cost of hiring workers increases substantially.

(a) This is a supply shock because affects the aggregate supply curve. This is a negative supply shock that shifts the AS curve to the left.

(b) This will affect the economy by shifting the AS to the left and raising the price level. However, the level of output will fall in the short run.

(c) A monetary or fiscal expansion can bring the same output level but not the price so point A cannot be reached. This is done when money supply is increased (Monetary expansion), tax cut is applied or government spending is increased (Fiscal expansion). These shift the AD to the right and so level of output is increased. However, price level is increased as well. But economy reaches its full employment at C.