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

An adverse supply shock would reduce the capacity of the economy to produce, leading to a leftward shift of the LRAS curve (also an inward shift of the PPF). As the LRAS curve shifts leftward, Real GDP declines and the price level rises. The reduction in Real GDP will lead to a cutback in employment and the demand for labor will decrease, resulting in declining money wages. The combination of a higher price level and lower money wages will lead to lower real wages, as well. Less work and lower real wages push down incomes, so consumption and investment will decline. Deceased spending by households and businesses creates a decline in the volume of outstanding loans and the money supply falls. The AD curve will shift leftward as a result of the falling money supply. In this example, both the AD curve and the LRAS curve shifted, so some people might believe that the events were caused by the falling money supply (which shifted AD), when the change in money supply was really the effect of the shift in LRAS.