Question

A natural disaster ravaged the country of Tsunamia. The disaster led to widespread destruction of the infrastructure, buildings and even of the labor force. Assume that prior to the event the economy was at its short and long run equilibrium point. Next, assume that in the aftermath of the disaster the policy makers implemented the following policies:

a) an increase in the money supply

b) aggressive fiscal spending, part of which was geared towards rebuilding the country's infrastructure (hint: aside of being a source of demand, spending on infrastructure leads to lower costs of production for firms!)

Using the AS/AD model outline the (theoretical) effects of the disaster on the Tsunamian economy in terms of the overall price level and the equilibrium level of output. Make sure you discuss both the long run and short run effects. Next, discuss the effects of the two policies on the price level and on the equilibrium output. Formulate your answers in terms of shifts in the AS curve or the AD curve, or both, depending on the type of shock or policy you are dealing with. Explain the logic behind your answers i.e. why have the curve(s) and situate your answer :)

Answer 1

Initial equilibrium of the economy occurs at point E.The natural disaster will shift the aggregate supply curve of the economy leftwards to AS' and in the short run new equilibrium will occur at point E1. At this point equilibrium price level in the economy has risen to and level of real GDP has fallen. However, in the long run, expansionary fiscal policy of the government and expansionary monetary policy of the Central Bank will shift the aggregate demand curve of the economy rightwards to AD' and thus long run equilibrium of the economy will occur at point E3. AT this new point of equilibrium, the price level in the economy has risen and economy has reached its potential level of GDP.

Thus, the government and Central Bank intervention helped the economy to reach its potential level in the long run.