ECONOMICS ASSIGNMENT

QUESTION: Explain what is meant by a supply shock, indicate how a supply shock affects the
level of prices and output in the short run and long run.

ANSWER: Exogenous factors that shift both demand and supply curves in an economy are also
known as shocks to an economy because these events disrupt the economy by changing the
employment and output levels from their natural levels. The shock that shifts the aggregate
supply(AS) curve is called supply shock. Also this type of shocks to the economy alters the cost
of producing goods and services and, hence, the prices that firms charge. Moreover, due to their
direct effect on the price levels, supply shocks are also called price shocks. Here are some
examples to it:
1) A drought destroys crops, which results in the reduction of food supply and, hence, prices
go up.
2) An environmental law government passes, which requires firms to reduce their emissions
of pollutants. Firms passes this cost onto the customer.

The above events are the example of adverse supply shocks and we can show this by the help of
diagram below:

As we can see in the diagram the adverse supply shocks shift the AS curve upwards. If the
aggregate demand is held constant: the economy moves from point A to B, the price level rises
and the amount of output falls below its natural level and this is also known as stagflation
because it combines economic stagnation with inflation.
If go for long run analysis, as the supply shocks lowered the natural output levels and thus shift
the aggregate demand curve to the left establishing a new equilibrium where the society faces
unemployment and higher prices for the longer time, which the world faced at the time of World
War I and II.

QUESTION: How does the central bank accommodate in response to a supply shock in the
economy.

ANSWER: To accommodate the supply shocks central bank have two options. First, discussed
in the previous question i.e. keeping aggregate demand constant, as a result output and
employment are lower than the natural level. Eventually prices will fall to restore full
employment but the cost of this adjustment process is a painful recession.

The second option is to expand aggregate demand or shift it rightwards to bring the economy
back to a natural level of output. In this case the central bank accommodates the supply shock by
increasing money supply in the economy which results in a shift of aggregate demand curve to
the right and economy goes from point A to C immediately. The main drawback of this policy is
that the price levels are set permanently higher. We can show this by diagram as well: