Question

6. How does the sudden wildfire that hit most states effect the U.S. economy in the SR? Be sure to outline the effects on U.S GDP, the price level and unemployment. What policies should the fed embark on to bailout the economy from the effects of the wildfire?

Answer 1

A wildfire destroys crops in US, which decreases short run aggregate supply. SRAS curve will shift left, increasing price level, decreasing real GDP and increasing unemployment, thus giving rise to a stagflation in short run. To bailout the economy, Fed should implement expansionary fiscal policy to increase money supply and lower interest rates (by open market purchase of federal securities and/or by lowering discount rate and/or by lowering reserve ratio), to increase investment and therefore, increasing aggregate demand. AD curve shifts rightward, intersecting new SRAS curve at further higher price level but restoring original real GDP to potential GDP level and restoring unemployment rate to its full-employment level.

In following graph, a fall in aggregate supply makes SRAS0 shift leftward to SRAS1, intersecting AD0 at point B with higher price level P1 and lower real GDP Y1. With Fed's intervention, AD0 shifts right to AD1, intersecting SRAS1 at point C with further higher price level P2 and restoring real GDP to potential GDP level Y0.