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Suppose that a country suffers from a major natural disaster. -Using a graph of aggregate demand...

Suppose that a country suffers from a major natural disaster.
-Using a graph of aggregate demand and supply, show the effects of this event on the economy if the policy makers do not intervene. Describe the effects on inflation and output.
-What will be the effect on the real interest rate, the inflation rate, and the output level if the central bank decides to stabilize the inflation rate? Is there a tradeoff between output stability and price stability?

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Answer #1

1) The disaster affectes the economy's production and shifts the aggregate supply curve leftwards to AS1. The peice level increases in the economy and the oputput falls below the full employment level. This leads to recession in the economy. The shortru equilibrium is at T.

2) To stabilize the interest rate, exanionary monetary policy is used, which shifts the AD curve rightwards to AD1. The price level increases to P2 and output is back to its full employment level. Thus the economy achieves output stability at the cost of high inflation at the point K.

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