Question

2. Suppose that there is a natural disaster hits that destroys part of the nation's capital stock. 

(a) Illustrate the effects this has on aggregate output, consumption, and leisure using the the Closed economy One-period Macroeconomics model. 

(b) Explain the effects on employment, and the real wage with reference to income and substitution effects. Which effect dominated in your graph in (a)? 

(c) Do you think that changes in the capital stock are a likely cause of the business cycle? Explain with reference to your answer to part (a) and the key business cycle facts described in chapter 3.  

Answer 1

Part A

The impact of natural disaster will be caused to lose the country’s capital stock. This will lead to shifting the consumption possibility frontier shifts down, and the marginal product of labor decreases. Graphically,

PPF2 PPF1

In the graph, the economy starts at point A at PPF1. The decrease in capital stock would shift the PPF1 to PPF2. Then aggregate output decreases. Moreover, consumption will decrease. The change in leisure depends upon the change in income and substitution effect.

M to N—Total effect

M to K –Substitution effect

K to N –Income effect

Part B

The lower marginal productivity of labor implies that lower real wage rate and employment. So the consumer will substitute employment to leisure. Since the production possibility frontier outskirts move down, there is additional income effect. The income effect infers less of the two goods: less consumption and less leisure (more work). On net, consumption must fall, be that as it may, leisure could diminish, continue as before, or increment, depending on the general qualities of the income and substitution effect. The circumstance portrayed on the figure beneath speaks to the situation when the income impact rules and the family achieves less leisure in the new equilibrium point C.

Part C

It impacted on the business cycle. The important effects are,

Consumption becomes procycle

Employment also will be procycle

The real wages is procycle