economics homework question about aggregate supply and demand, need help!?
You’ve considered two different economic shocks resulting from Katrina:
1) An aggregate supply shock: Katrina increased energy prices and temporarily reduced U.S. productive capacity.
2) An aggregate demand shock: Government responded to the hurricane with massive expenditures on aid and rebuilding.
What does the aggregate supply and aggregate demand model predict about the combined impact of these shocks on the U.S. economy?
A. Real GDP may rise or fall, but the price level will definitely rise.
B. Real GDP will definitely fall, but the price level will definitely rise.
C. Real GDP may rise or fall, but the price level will definitely fall.
D. Real GDP will definitely rise, but the price level may rise or fall.
I think it’s A, because only the price level changes in the long run, correct?
Tagged with: aggregate supply and aggregate demand • demand model • economic shocks • economy • energy prices • expenditures • gdp • hurricane • katrina • level changes • productive capacity • real gdp • supply and aggregate demand • supply shock
Filed under: Hurricane Questions
Like this post? Subscribe to my RSS feed and get loads more!
You are right, the correct answer is A, but not necessarily for the reason you give. It’s not necessarily true that only the price level will change; Real GDP may change, but the direction of the change cannot be determined by the information given.
The question is asking you to determine the effect of these two economic shocks on equlilibrium output (real GDP) and price level.
Consider the standard diagram with price level on the y-axis and real GDP on the x-axis, with a downward-sloping aggregate demand curve and upward-sloping aggregate supply curve; the equilibrium point is where these two curves intersect.
In the first case, the aggregate supply shock would be represented by a leftward shift in the aggregate supply curve. This shift by itself would create a new equilibrium with a lower real GDP, and a higher price level.
In the second case, the aggregate demand shock would be represented by a rightward shift in the aggregate demand curve. This shift alone would create a new equilibrium with a higher real GDP, and a higher price level.
When you put these two shifts together, you see that both will cause the price level to be higher, so the price level will definitely rise. The first shift will cause real GDP to fall while the second will cause real GDP to rise, so together it cannot be determined whether real GDP rises or falls; it would depend on which shift would be greater.