Question

1. Describe the sequence of events that real business cycle theorists would use to explain how an adverse supply shock would impact the economy. Use your answer to explain why it is easy to confuse cause and effect between changes originating on the supply side and those that begin on the demand side.

Answer 1

The unexpected events occurred in the economy lead to boom or curse in the business cycle. These dramatic changes will affect the future output and growth rate. The adverse supply shock occurred due to the unexpected increase in costs of production. This may be rise in price of factors, rising wage rates, high level of hiring rate of workers, low level of investments etc. This will make an adverse supply shock in the production process. This adverse supply shock will shift the short run aggregate supply curve to left. And this shift leads to higher inflation rate and lower level of output. This will reduce the real GDP also. Rising oil prices, bad weather, declining the productivity rate, wage push inflation, devaluation or depreciation of exchange rates, supply shock due t poor harvest are the major adverse supply shocks occurred in our economy. This supply shock will lead to recession and retards the economic growth.
This adverse supply shock will lead to demand side deficiencies also. The rising cost of production will reduce the total production and this affect the employment rate also. The unemployment rate increased in the economy due to this supply shock. This unemployment rate will reduce the consumption pattern and lower the aggregate demand. The lowering aggregate demand will increase the price level and this also reduces the output level. This will affect the investment level and the real GDP rate. This will continue for long time as demand side effects and supply side effects.