Question

10. Consider a one-period economy which experiences the destruction ofsome of the nation’s capital stock (say through a hurricane is destroyed). How should this effect equilibrium, consumption, output and labor supply? Now, let’s say the government tries to offset some of the declines in capital on output and hours worked by increasing government spending. What is the likely outcome of this policy intervention in terms of consumption?

Answer 1

When there is destruction of capital stock , production falls in the economy . So aggregate supply falls . This causes rise in price level and fall in equilibrium GDP . Output falls , labor supply is not much affected as the hurricane has destroyed only capital stock . Consumption demand falls because of loss of property and fall in income . So it creates a situation of recession .

Expansionary fiscal policy increases money supply which raises spending in the economy . As government spending rises , more capital is created and labor productivity rises , this causes increase in output and income . This raises consumption demand in the economy .