Question

a) Discuss, with examples, factors or events that might shift the short run aggregate supply curve. [10 marks]

b) Imagine an economy is in long run equilibrium. Now suppose that firms experience an increase in their cost of production (say, due to a natural disaster).

i. Explain, with graphs, the macroeconomic impact of such an increase in production costs.

ii. Describe how policymakers could use fiscal policy to counteract the effects of increased cost of production. [15 marks]

Answer 1

a) Change in Cost of Production.

An increase in cost of production leads to a leftward shift in the short run Aggregate Supply Curve. A Decrease in the cost of Production leads to a rightward Shift in the short run Aggregate Supply Curve. Suppose oil is a major input used in the production. If the price of oil goes up, production cost go up. Firm would supply less at the market price. Thus, Short run Aggregate Supply Curve would shofy to the left.

An Change in technology

An improvement in technology leads to a rightward Shift in the Short Run Aggregate Supply Curve and vice versa. Suppose, a Technological Improvement leads to efficient utilisation of labour, firms' output would Increase and thus firms would supply more at the same price level and Short Run Aggregate Supply Curve would shift to the right.

Change in Productivity.

An increase in Productivity leads to a rightward Shift in the Short Run Aggregate Supply Curve and vice versa. Given the same input, firms would Produce more. Thus, At the same price firms would produce more. Aggregate Supply Curve would Shift to the right.

b) i) As can be seen from the Diagram, Increase in Cost of Production leads to an increase in Price Level and Decrease in Output in the Short Run.

ii) The action of policymakers depends on the priority he gives to Inflation or Output maintenance more. If he wants to stabilize prices, he would use Contractionary Fiscal Policy. If he wants to maintain output at the potential level, then he would have to use Expansionary Fiscal Policy but this would come with more inflation.