Question

There were two major shocks to the U.S. economy in 2007, leading to the severe recession of \(2007-2009\). One shock was related to oil prices; the other was the slump in the housing market. This question analyzes the effect of these two shocks on GDP using the \(A D-A S\) framework. a. Draw typical aggregate demand and short-run aggregate supply curves. Label the horizontal axis "Real GDP" and the vertical axis "Aggregate price level." Label the equilibrium point \(E_{1}\), the equilibrium quantity \(Y_{1}\), and equilibrium price \(P_{1}\). b. Data taken from the Department of Energy indicate that the average price of crude oil in the world increased from \(\$ 54.63\) per barrel on January 5,2007 , to \(\$ 92.93\) on December 28,2007 . Would an increase in oil prices cause a demand shock or a supply shock? Redraw the diagram from part a to illustrate the effect of this shock by shifting the appropriate curve. c. The Housing Price Index, published by the Office of Federal Housing Enterprise Oversight, calculates that U.S. home prices fell by an average of \(3.0 \%\) in the 12 months between January 2007 and January 2008 . Would the fall in home prices cause a supply shock or demand shock? Redraw the diagram from part b to illustrate the effect of this shock by shifting the appropriate curve. Label the new equilibrium point \(E_{3}\), the equilibrium quantity \(Y_{3},\) and equilibrium price \(P_{3}\) d. Compare the equilibrium points \(E_{1}\) and \(E_{3}\) in your diagram for part \(c .\) What was the effect of the two shocks on real GDP and the aggregate price level (increase, decrease, or indeterminate)?

Short answer

The two shocks resulted in a decrease in real GDP (from \(Y_1\) to \(Y_3\)). The effect on the aggregate price level is indeterminate without more information on the relative shifts of the AD and SRAS curves.

Step-by-step solution

Drawing the AD-AS Model

Begin by drawing the typical aggregate demand (AD) curve, which slopes downward, and the short-run aggregate supply (SRAS) curve, which slopes upward. The horizontal axis is labeled 'Real GDP' and the vertical axis is labeled 'Aggregate price level'. The intersection point of the AD and SRAS curves is the initial equilibrium point, labeled as \(E_1\), with equilibrium quantity \(Y_1\) and equilibrium price \(P_1\).

Impact of Increased Oil Prices

An increase in oil prices is a negative supply shock because it makes production more expensive, reducing the quantity supplied at every price level. Redraw the initial diagram and shift the SRAS curve to the left to represent the increase in oil prices. This shift leads to a new equilibrium where the real GDP is lower and the price level is higher. Label the new equilibrium point, but do not change the labels \(Y_1\) and \(P_1\) yet.

Impact of the Housing Market Slump

A fall in home prices is a negative demand shock since it decreases consumers' wealth and thus their spending. Redraw the diagram from the previous step and now shift the AD curve to the left to show the decrease in aggregate demand due to the housing slump. This will lead to a new equilibrium with a further reduced real GDP and a potentially lower or higher price level depending on the relative shifts of the curves. Label this new equilibrium point \(E_3\), and label the new equilibrium quantity \(Y_3\) and equilibrium price \(P_3\).

Comparison of Equilibrium Points

Compare the initial equilibrium point \(E_1\) with the final equilibrium point \(E_3\) in the diagram. The effect of the two shocks is to decrease real GDP (from \(Y_1\) to \(Y_3\)) as both curves have shifted to the left. As for the aggregate price level, it is indeterminate without specifying the magnitude of the shifts. The price level could increase, decrease, or remain the same, depending on the relative strength of the demand and supply shocks.

Key concepts

Supply Shock

A supply shock refers to an unexpected event that suddenly changes the supply of a product or service, which can significantly impact the price level. For instance, an increase in oil prices, as seen in the 2007-2009 recession, can lead to a negative supply shock. This is because oil is a primary input for many goods and services. As production costs rise, the quantity of goods that businesses are willing or able to supply at a particular price decreases.

In the AD-AS model, a negative supply shock is represented by a leftward shift of the Short-Run Aggregate Supply (SRAS) curve. The result is typically a higher price level and lower output, which could potentially cause stagflation—a combination of inflation and stagnation of economic output. Additionally, a significant supply shock can lead to increased unemployment and a decrease in the nation's overall economic activity.

Demand Shock

A demand shock, on the other hand, occurs when there is a sudden surge or decline in consumer demand. The housing market slump in 2007 can be characterized as a negative demand shock, where the drop in home prices reduced consumer wealth and subsequent consumer spending. This contraction in aggregate demand can lead to lower prices and lower output.

In the graphical AD-AS framework, this is shown as a leftward shift of the Aggregate Demand (AD) curve. The impact of a negative demand shock in the short run is a reduction in the real GDP and an ambiguous effect on the price level; prices might fall due to reduced demand, or they might not change significantly if the supply remains unaltered. In the long term, persistent demand shocks can slow economic growth and contribute to higher unemployment rates if markets do not adjust accordingly.

Aggregate Demand

Aggregate Demand (AD) encapsulates the total quantity of goods and services demanded across all levels of the economy at different price levels, ceteris paribus. It includes consumption by households, investments by businesses, government expenditures, and the net effect of exports and imports. The AD curve typically has a downward slope, indicating that as the general price level decreases, the quantity of goods and services demanded increases, and vice versa.

A key factor affecting AD is consumers' and investors' expectations. For example, during a recession, if consumers expect prices to fall, they may delay purchases, which further reduces AD. Meanwhile, businesses anticipating poor sales may cut back on investment, exacerbating the situation. Hence, AD is an essential concept in understanding the dynamics of the economy, especially in fluctuations such as recessions.

Aggregate Supply

Aggregate Supply (AS) refers to the total quantity of goods and services that producers are willing and able to supply at a given overall price level. There are two versions of the AS curve: the Short-Run Aggregate Supply (SRAS) curve and the Long-Run Aggregate Supply (LRAS) curve. The SRAS curve slopes upward, indicating that a higher price level encourages more production due to the potential for increased profits. However, in the long run, the LRAS is vertical, reflecting the economy's potential output, independent of the price level, given fixed resources, technology, and institutional structures.

Supply shocks shift the SRAS curve, as seen with heightened oil prices, impacting the short-term production costs. Understanding AS is pivotal, as factors that affect production—such as technological advances or changes in input costs—can significantly influence an economy's output and price level, representing the supply side's response to economic conditions.