Question

7. (10 Points) Explain and demonstrate graphically the effects of a negative supply shock in both the short-run and long-run. (Hint: Use AD-AS framework)

Answer 1

Negative supply shock influences the aggregate supply curve and therefore the supply curve shift to the left. In the short run there is an increase in the level of prices and a decline in the real output. However over the period of time as nominal wages adjust, aggregate supply curve shifts to the right, thereby attaining the same level of prices and the level of output as before.

Pricq Pricq LRAS SRAS2 LRAS ,SRAS2 SRAS I SRAS1 P1 Pf Pf AD1 AD1 Real GDIP Real GDP Yl Yf Yl Yf In the long run as price level rises, real wages fall and firms hire more labor, which increases production and shifts SRAS back to its original location. Both real GDP and prices have reached their original long run levels In the short run there is a leftward shift of the SRAS supply which reduces the real GDP but raises the nrice level.