Supply Shocks and GDP. Recall that supply shocks are external events that shift the supply curve. These shocks shift the short-run aggregate supply curve. For example, the prolonged fall in oil prices...

Supply Shocks and GDP. Recall that supply shocks are external events that shift the supply curve. These shocks shift the short-run aggregate supply curve. For example, the prolonged fall in oil prices that started in June 2015 will shift the short-run aggregate supply curve downward because firms’ costs have fallen and firms charge lower prices.

a.Based on the above analysis, some economists expect higher GDP in 2016. Assuming that an economy is initially at the full employment level, use the AS-AD model to explain how the fall in oil prices would affect the GDP in the short run and the long run. How will this affect the price level in the short run and long run? Graphically illustrate your answer.

b. On the other hand, some economists found that the fall in oil prices led to a significant cutback of capital spending by the energy industry in addition to boosting consumer spending. Suppose consumer spending contributes more to the GDP than investment spending, thereby leading to a higher GDP and lower price level in the short run. Graphically illustrate this result. What will be the long-run price and output?