Question one (20 marks)

1.1. Suppose a supply shock in the form of an earthquake causing big damage in most of the sectors of the economy. Use the AD'-AS' model to illustrate and explain the impact of this supply shock on inflation and output in the short- and long term. (5)

1.2 Suppose policymakers come under political pressure to counter the supply shock by means of expansionary fiscal policy. Use the AD'-AS' model to illustrate and explain whether they will be successful. (4)

1.2. Briefly discuss the three arguments that explain the positive relationship between the average price level and aggregate production (positive slope of the AS curve). (3)

1.3. Use AD-AS analysis to show how each of the following events will affect the equilibrium price level and real output in an economy in the short run when the aggregate supply (AS) curve is upward sloping. In each case, draw and appropriate diagram. 1.3.1. Labour unions successfully negotiate an increase in nominal wages for their members. (4) 1.3.2. Consumer expects the economy to go into recession. (4)