Y5

Productivity shocks

Suppose a natural disaster (such as an earthquake) destroys a newly installed technology, forcing producers to fall back on an old and inferior production method. The purpose of this question is to examine the macro eects of such adverse productivity shock viz., its eects on prices fw;W; rk;Rk; P; ;Rg and allocations fN;K;Y ; C;I;G;NX;S; mg in the short run and the long run. Let us analyze this problem in 2 stages.

(1) The immediate impact of this negative shock to the production function is to lower the marginal productivities of both labor (MPN) and capital (MPK) :

(a) Explain how this would aect the macro equilibrium via possible shifts in the production function and input demands.

(b) If this transitory shock creates any output (and/or employment) gap, propose a policy that can close the gap.

(2) If the shock is persistent (rather than transitory), it would also lower the expected future marginal productivities of both labor (MPNe) and capital (MPKe) as well as peoples expected future income (Y e) :

(a) Explain how these expectations eects would alter the macro equilibrium via possible shifts in the supply (Ls = S) and demand Ld = Iof loanable funds as well as the supply of labor services (Ns) :

(b) If this persistent shock creates any output (and/or employment) gap, propose a policy that can close the gap.