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“Everyone so this video is going to look at the effect of supply shocks on on the economy specifically i m going to be talking about negative supply shocks and will look at two possible response mechanisms to a negative supply shock. The first is known as a natural adjustment mechanism whereby. There is no intervention from either government or from the reserve bank and the second would be known as accommodating. The supply shock.
And that would involve some intervention from other treasury or the reserve bank. So the first point of call is to remember that when we re thinking about supply shocks. We re looking at the effect of in this case. Negative supply shock.
And that would the first effect of that would be to decrease the amount of goods and services. That films can supply a typical example of a supply shock would be an oil price increase. A big and sustained oil price increase for example and that has a pervasive effect on the ability of firms to supply goods and services. Particularly because the oil price effects firm s cost of transportation.
So what we have in terms of the diagram is an aggregate demand and aggregate supply model diagram remember when you told us to correctly label the axes on the horizontal axis. We re measuring wheel outputs on the vertical axis were measuring the price level the aggregate demand curve is negatively sloped. Because as the process of goods and services increase. The quantity of goods and services demanded will decrease and here i ve drawn in a positively sloped aggregate supply curve suggesting that as process increase firms become willing to supply more at the higher price.
The equilibrium is at a where the past level is pa. And the equilibrium level of real output is y. A at this point. It s probably important to note that at point.
A the nominal wage is w a and the real wage would be the nominal wage adjusted for prices so just remember that the nominal wage refers to the face value of the wage that people receive while the real wage refers to the purchasing power of the wage that people receive okay so if we have a supply shock. The effect of that supply shock is going to be to decrease the supply of goods and services and the abacus supply curve shifts to the left that will create excess demand at the existing price level. So if you have a look here when the supply for goods and services decreases. Because of say an oil price increase.
Then the amount which is demanded at the past level pa. As y. But the amount which ends up being supplied. Because the supply of goods and services.
Decreases. Is less than that say y prime and this means. That there is an excess demand for goods. And services.
Demond. Y. A exceeds supply y prime and the consequence of that is that upward pressure will be placed on the price level and as prices rise this then causes the economy to move to the new equilibrium. Which is at the intersection of the aggregate demand.
Curve and the new aggregate supply curve all right so the big issue with supply shocks is that they caused two bad things in the economy to happen at once at point b. The price level is now p b..
And nerds that p b. Is higher than p. A. So the effect of the supply shop is inflationary prices go up and in addition.
The new equilibrium level of outputs is yb. And so the consequence of the supply shock in terms of real outputs is that real outputs is less than before so the level of outputs declines. So that s two bad things happening at once prices rise output falls. The other thing just to note is that as output falls.
We can also recognize that changes in output. Often affect employment and so that as output decreases employments is also falling all right so that s the kind of basic mechanism of the supply shock happening what can be done about it the first kind of thing to look at is that it s possible for governments and reserve banks to not do anything. And we call this a natural adjustment mechanism and in a natural adjustment mechanism. The government and the reserve bank would rely on the fact that over time the economy would be able to naturally adjust to the supply shock.
Without any further into the or without any intervention from other the government in terms of fiscal policies. Or the reserve bank in terms of monetary policies. So a natural adjustment mechanism basically means do not interfere don t do anything if the government and the reserve bank decide not to interfere not to do anything. It is possible that provided there are no additional shocks to the system that the economy could adjust back to the full infer or back to the original level of output by itself so a natural adjustment mechanism basically means do nothing and if we do nothing how is it that the economy could adjust back up to the original level of output and to the elliptic to the original lower possible well the idea here is that when output falls this decrease in outputs is associated with the decrease in employment employment falls or unemployment rises.
If nothing is done formally in the economy. It could be argued that over time the bulk of the unemployed people the kind of rising amounts of unemployment in the economy will put downward pressure on the nominal wage. So over time the nominal wage will fall. So the idea is that people who become an employee.
Then who are without work will eventually become willing to work for less and that panic places downward pressure on nominal wages and as nominal wages fall that then over time will mean that firms costs of production will be lowered. And as firms. Cost of production are lowered. This a new aggregate supply curve.
A s1 will actually gradually move back to its original position at a s. So. Maybe i should just label these so that it s clear this would be one for the supply shop and this would be the direction of the aggregate supplier code of the chef for where and when when the nominal wage started to fall so as nominal wages for all firms costs of production are going to decrease s pen s cost of production decrease. The aggregate supply curve moves back to its original position at a s and this to be quite a long lengthy gradual adjustments.
But eventually the economy will move back to the original equilibrium points. I m giving it a different label here because at this equilibrium point. Which happens after the natural adjustment mechanism. Although the price level has returned to what it was before the supply shock.
And although. The equilibrium level of output has returned to what it was before the original or before the supply shock. There is something. Which is different in the equilibrium.
At c relative to the equilibrium at a and what s difference is both phenomenal and the real wage sir at a as we had indicates at the nominal wage was w. A and the real wage was w..
A. Or the p. A fb fb. The nominal wage is now w.
B. Why well because remember that women natural adjustment mechanism to take place the nominal wage has to fall. Which caused firms cost of production to fall. So the nominal wage is not w.
Is now w. Cerise wc. Okay at that point and x. Wc wc is this then w a okay and if we were to now compare the real wage.
The real wage is wc over okay so the big difference then between queens. A. And what i ve labeled as queen seen is that at points a the nominal wages w. A and the real wages w a or the pa okay why is the supply shock.
Has happened. And once the economy has followed a natural adjustment mechanism. Which has been able to ensure that prices move back down to their original level and output increases back up to its original level. There is still a difference in the equilibrium at a versus.
The new equilibrium. If you want to call it best xc and the big difference is in both the nominal wage and the real wage. This is because in order for the natural minute adjustment mechanism to take place the nominal wage have to fall. So let s see the nominal wage is lower than what it was at a and in addition.
The real wage is lower than what it was at a so even though the natural adjustment mechanism is able to ensure that classes return to the original level and that upward unemployment which returns to its original level there is still a cost to people in the economy because birthday nominal wage and therefore the real wage is lower than what it was before the supply shock. Them sort be just as a kind of quick summary. Then if we reits way to compare place. A and point c.
At point. A the price level is pa. The level of output is y. A the nominal wage is w.
A. The real wages w. A over pa. At point c.
The price level is pa. The opera table is why a so those things are the same..
But the nominal wages wc and the real wages wc over pa. And the important thing to note. Is that wc is less than w. A.
So the nominal wage at point c is less than the nominal wage at point a and in addition. The real wage therefore at point c is less than the real wage at point a ok. So that s the natural adjustment mechanism. One thing to note is that with the natural adjustment mechanism.
It is not something which governments typically like to follow why well because it s not certain how long it is going to take for this natural adjustment mechanism to unfold and one of the big concerns is that if the unemployment that is generated when upward falls persists for a long period of time it could result in unemployment hysteresis. Which as you should know by now means that people who have lost their jobs and who don t quickly regain employment eventually must become unemployable because they lose the skills and experience that are associated with being active employed people ok. So that s the natural adjustment mechanism. What we want to do is think about what would happen under f accommodating policy.
So what i m gonna do is i m just going to put another piece of paper here and we draw the supply shop diagram. So it won t take very. Long for me to do this aggregate demand aggregate supply class level p real outputs. Y equilibrium price level equilibrium level of upwards and we want to draw in the supply shop.
And this is pp. Why leave sorry that was incorrectly labeled. Okay. And this is point b.
And so what this particular diagram is going to look at is accommodating the supply shock. Okay so like in the previous example. There is a supply shocks such as a big increase in the price of oil and the effect of that is to raise the equilibrium price level and lower the equilibrium level of real output. It s particularly fair for an economy that experienced as a supply shock because they experienced both rising inflation and rising levels of unemployment.
The question then in this case is well will the government do anything about it or the reserve bank. Do anything about it and if they do what would it look like when we talk about accommodating. The supply shock. We are thinking about either the government or the reserve bank implementing expansionary policies.
Typically in order to try and redress. The rising unemployment that happens when a supply shock curve occurs particularly because of the concern of unemployment. Asturias governments and reserve banks. May not want to permit the economy to follow a natural adjustment process and would be much more keen to try and get the economy out of that rising unemployment situation sooner rather than later so with an accommodating alley or accommodating the supply shock.
We re talking about say. The treasury. Which is government s implementing expansionary. The school policy or the reserve bank implementing expansionary monetary policy and both of those policies together served to increase the demand for goods and services.
So what i m going to do is to draw in how an expansionary monetary or fiscal policy. Would affect the economy and the way in which it affects the economy is through increasing the demand for goods and services..
So when we accommodate a supply shock. That means that other the treasury or the reserve bank are going to use expansionary monetary or fiscal policies to try and increase the demand for goods and services when they do that when they increase the demand for goods and services. That s represented by a rightward shift of the advocate demand curve from 80 to 81. So ad increases from 80 to 81.
When that happens the excess demand puts upward pressure on the price level so a more upward pressure on the prostate. Which is less than ideal talk about that in a second and the one thing that the expansionary monetary or fiscal policy is able to then address is that the level of outputs is able to increase back to the original level of outputs. Okay. So the reason why accommodates and policies might be used is because the unemployment that gets chipped that gets generated when the supply shop happens can be redressed through an expansionary demand side policy.
Which incentivizes firms to increase production. Because the demand for the goods and services is increasing the one thing that you should note. Though is that when we accommodate the supply shock. Although it is possible for the economy to move back to the level of output that they started at before the supply shock prices will rise even further.
So there is a cost even to accommodating the supply shock. And that is that process increase even more in an economy. Which is has and suffered a supply shock. The other thing to think about is what s been going on with the nominal and the real wage.
When you accommodate the supply shopping. So at point a we can see or we can say that the nominal wage was w. A and the real wage would have been w a over the pa when the supply shocks. Happened and we moved from a to b the nominal wage was still w a.
But the real wage would have been w b or the pa. So that s the real wage at b. That s the real wage at a f quincy. The real wage would have been sorry.
This is w. A. Or the p. Witnessing and at point c.
The real wage would have been w a over pc. And so that s the real wage. Okay so the big thing to nurture is that the real wage at a is higher than the real wage at e. And that s higher and the real wage at c.
So there is no easy way out of a supply shock as i suppose the points even when you follow a natural adjustment mechanism. The real wage falls in that case the real wage fall and the nominal wage has fallen when you accommodate the supply shock. There is no change to the nominal wage that the purchasing power of people s money does go down the real ” ..
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