Question

11. Consider an economy that abides by the standard classical model specifications. Suppose the economy experiences an earthquake that destroys a large amount of capital in the econ- omy (assume the population in unaffected and thus remains constant). Using graphs and written discussion, examine the economy dynamics in the wake of the shock Expectations are as follows: . Capture the timing in your written discussion If a curve shifts, explain why/economic intuition . If a market is in disequilibrium, explain how it returns to equilibrium . Explain, if possible, the final outcome in terms of important variables: Y,N, P,C, w

Answer 1

Under our above assumption, the economy which experience earthquake shall face an adverse supply shock because of the consequences.

This will lead to lower incomes and lower consumption and high losses amongst it citizens. Due to the earthquake and mass destruction the supply fals drastically and demand for basic goods will be naturally higher which will lead to sudden shoot in prices and thus equilibrium level will be disturbed. Thus the real GDP comes down as well. The lower output and massive unemployment will lead to lowered wages as well.

The economy however returns to equilibrium in long run due to imports from countries havi g comparative advantage and due to expansionary fiscal policy as well as automatic stabilizers.

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