Question

Using the aggregate supply and demand model, illustrate what will happen in the short run and long run when the economy suffers a supply shock.

Answer 1

Supply shock refers Decrease in aggregate supply. For example increase in oil prices, Because oil is an essential input of almost every industry. So Increase in oil price , increase average production cost in economy ,as a result aggregate supply Decrease and AS curve shift left..

Decrease in aggregate supply, create shortage of good at intial equilibrium price level.,which lead to increase in price level and equilibrium GDP in short run.

In long run;
If supply shock remain temporary,then high unemployment ,lead to lower wages and thus increase aggregate supply and increase GDP to same full employment level gdp and Decrease price level .

But shock is permanent, then it will decrease full employment level gdp permanently and LRAS shift left. So in long run the Equilibrium GDP will be equal to new full employment gdp and price level will permanently increase.