7. 7. Positive and negative supply shocks The following graph shows several shif

Question

7. 7. Positive and negative supply shocks

The following graph shows several shifts in the short-run aggregate supply (AS) and aggregate demand (AD) for a hypothetical economy. Initially, the economy is in long-run equilibrium at its potential output, $80 billion. Note that you must determine from the scenario that follows whether the initial equilibrium is given by point J or L PRICE LEVEL 140 RAS 130 120 110 100 ADy 90 80 ADx 70 60 60 65 70 75 80 85 90 95 100 REAL GDP (Billions of dollars) Suppose a bout of severe weather drives up agricultural costs, increases the costs of transporting goods and services, and increases the costs of producing goods and services in this economy. The increase in production costs causes a shift from ADx toA short run. (Note: For simplicity, ignore any possible impact of the severe weather on potential output.) Dy and it moves the economy from point to point in the True or False: The short-run economic outcome resulting from an increase in production costs is known as stagflation O True O False In the absence of government intervention, the level of employment and output attained in the short run wil eventually begin to put upward run to the long run. In the long run, the price level in the economy will be 120, and the quantity of output in the economy will be $80 billion. This is pressure on wages and prices as the economy transitions from the short consistent with the prediction made by the classical model

Explanation / Answer

(7.7)

(a) Increase in production costs causes shift from ASx to ASy [Since, firms will lower output if production cost rises, and this will shift AS curve to left], and moves the economy from point J to point K.

[Since, after the negative output shock, AS will shift leftward, the initial AS curve must be ASx, and therefore initial AD curve must be ADx, and initial equilibrium is at point J]

(b) TRUE

A stagflation occurs when real GDP falls but price level rises, as is in this case.

(c) Level of employment and output will put Upward pressure on wages and prices. In long run, price level will be 110 [Since new long run equilibrium is at point L, where ASy intersects new AD curve, ADy] and quantity of output will be $80 billion [Real GDP will equal potential GDP]. This is consistent with Classical model.

NOTE: As per Chegg answering policy, 1st question is answered.

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