Answer to Question #277504 in Microeconomics for Noxolo Tshuma

Question

n increase in the price of oil is an example of a negative supply shock. Use the AD-AS model graph to explain the effect of a negative supply shock on the price levels and output levels in the economy.

(Note: Five marks will be awarded for the graph and five marks will be awarded for the explanation.)

Answer 1

The diagram above demonstrates a negative supply shock; The initial position is at point A, producing output quantity Y₁ at price level P₁. The occurrence of a supply shock in this case an increase in the oil price has an adverse effect on aggregate supply: the supply curve shifts left (from AS₁ to AS₂), while the demand curve stays in the same position. The intersection of the supply and demand curves has now moved and the equilibrium is now point B; quantity has been reduced to Y₂, while the price level has been increased to P₂.

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