Question

Consider an economy that abides by a Dynamic AS/AD model as presented in class, which, in period t-1, is in a short equilibrium that happens to coincide with a long run equilibrium. In period t there is a adverse supply shock. The shock remains for 2 periods (t, t+1), but then dissipates fully in period t+2. Describe how this economy reacts to this shock from periods t-1 through t+2. Also discuss how the economy might transition to a LR equilibrium. Graphs of DAD/DAS space and written discussion are required.

Answer 1

In t-1 equilibrium is reached at the intersection of AD and AS at e, with Yt-1 and Pt-1. Adverse supply shock supply reduces which shifts AS leftwards to AS'. New equilibrium is reached at e' in t, with higher price level Pt and lower output Yt. The equilibrium remains at e' till period t+1. In t+2 aggregate supply by adjusting. When output is below full employment or long run level, number of workers demanded is less which leads to lower wage rate. Lower wage is a decrease in cost of production. This leads to increase in aggregate supply and AS' shifts back to its original level AS. Equilibrium returns to Yt-1 and Pt-1.