ECS 3703
OCT/NOV 2021 EXAM MEMO
SPECIFIC FOR JAN/FEB SUPP EXAMS
FOR FURTHER ASSISTANCE CONTACT
THE BOOK FOUNDATION
+27 63 980 7442
, Question 1
Explain, with reference to a graph, the effect of adverse supply shocks in an economy.
Refer to a graph in the prescribed book and name the graph. You do not have to draw the
graph.
The graph in the prescribed book is Fig 19.12, Macroeconomic Policies to adjust to supply
shocks.
A supply shock is an event that suddenly increases or decreases the supply of a commodity or
service, or of commodities and services in general. This sudden change affects the equilibrium
price of the good or service or the economy's general price level.
In the diagram, the original long-run equilibrium point is E with PE and YN at the intersection of
the LRAS, SRAS, and AD curves. The immediate effect of a large increase in petroleum prices
leads to a shift in the nation’s short-run aggregate supply curve from SRAS to, say, SRAS1. This
defines the new equilibrium point E1 where the price P1 is greater than PE. And Y1 is less than
the original YN.
The combination of recession or stagnation and higher prices or inflation at point E1 is referred
to as stagflation. The lower level of natural output and employment at YN1 , however, causes
prices to fall, thus lowering costs and shifting the SRAS1 curve down and to the right, but not all
the way back to SRAS . The reason is that long-run production costs have also increased as a
result of the increase in petroleum prices, and so the LRAS curve has also shifted to the left, say,
to LRAS1. As such, the new long-run equilibrium point E2 is obtained at the intersection of the
LRAS1, SRAS2, and AD curves at P2 < P1 and YN2 > YN1 . At point E2, prices are higher and
the natural level of output and employment is lower than at point E before the petroleum shock.
OCT/NOV 2021 EXAM MEMO
SPECIFIC FOR JAN/FEB SUPP EXAMS
FOR FURTHER ASSISTANCE CONTACT
THE BOOK FOUNDATION
+27 63 980 7442
, Question 1
Explain, with reference to a graph, the effect of adverse supply shocks in an economy.
Refer to a graph in the prescribed book and name the graph. You do not have to draw the
graph.
The graph in the prescribed book is Fig 19.12, Macroeconomic Policies to adjust to supply
shocks.
A supply shock is an event that suddenly increases or decreases the supply of a commodity or
service, or of commodities and services in general. This sudden change affects the equilibrium
price of the good or service or the economy's general price level.
In the diagram, the original long-run equilibrium point is E with PE and YN at the intersection of
the LRAS, SRAS, and AD curves. The immediate effect of a large increase in petroleum prices
leads to a shift in the nation’s short-run aggregate supply curve from SRAS to, say, SRAS1. This
defines the new equilibrium point E1 where the price P1 is greater than PE. And Y1 is less than
the original YN.
The combination of recession or stagnation and higher prices or inflation at point E1 is referred
to as stagflation. The lower level of natural output and employment at YN1 , however, causes
prices to fall, thus lowering costs and shifting the SRAS1 curve down and to the right, but not all
the way back to SRAS . The reason is that long-run production costs have also increased as a
result of the increase in petroleum prices, and so the LRAS curve has also shifted to the left, say,
to LRAS1. As such, the new long-run equilibrium point E2 is obtained at the intersection of the
LRAS1, SRAS2, and AD curves at P2 < P1 and YN2 > YN1 . At point E2, prices are higher and
the natural level of output and employment is lower than at point E before the petroleum shock.
