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Suppose a massive and severe natural disaster reduces potential output in the economy. Use the ADI-SRIA...

Suppose a massive and severe natural disaster reduces potential output in the economy. Use the ADI-SRIA diagram and show the effect of a permanent decrease in potential output on the economy in the short run and long run. Assume that the economy initially has an inflation rate of π0 and full-employment output at Yf.

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Answer #1

The initial equilibrium in the economy occurs at point E1 where AD=SRAS=LRAS in the economy. The disaster will reduce the level of output produced in the short run at each price level and this will lead to leftward shift of the SRAS curve leftwards to SRAS' and this increases price level and Real GDP in the economy.This is depicted in the diagram below:

In the long, this massive destruction will also decrease production capacity of the economy and thus reduce potential level of output produced in the economy. This will shift the LRAS curve leftwards to LRAS' and the full employment level of Real Output decreases to OYf'.

Thus, natural disaster caused in the economy has reduced the level of potential output in the economy permanently in the economy.

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