Which of the following could create an increase in the price level and a reduction in real GDP?
a. tax rebates
b. a fall in stock prices
c. declining government expenditures
d. natural disasters such as hurricanes and famines
The correct answer and explanation is:
The correct answer is d. natural disasters such as hurricanes and famines.
Natural disasters, like hurricanes and famines, can cause a reduction in real GDP while increasing the price level. Here’s why:
When a natural disaster occurs, it leads to widespread destruction of infrastructure, homes, businesses, and agricultural production. This significantly reduces the economy’s capacity to produce goods and services, which directly leads to a decrease in real GDP. The supply of goods, especially essential ones like food and fuel, can be interrupted. This supply-side shock decreases the economy’s overall production capacity, leading to lower output.
At the same time, the disruption of production and supply chains can lead to an increase in prices. With fewer goods available and continuing demand for them, the scarcity of resources drives up prices, causing inflation. For example, if a hurricane damages oil refineries or agricultural areas, the reduced supply of these products can result in higher prices.
The combination of reduced output (lower real GDP) and higher prices (inflation) is referred to as stagflation, a situation that policymakers often find challenging to address because typical economic tools aimed at reducing inflation can further depress output, and those aimed at boosting output can fuel inflation.
Other options, like tax rebates, fall in stock prices, and declining government expenditures, typically influence demand in different ways. While they can affect economic activity, they do not usually create the same dual effect of reducing GDP while simultaneously increasing prices in the manner that natural disasters can.