Question

cam, the economy is in long- uilibrium at point E, when an 4. In the accomo run macroes oil shock shifts th to SRAS. Bas, questions. ccompanying diagram, the economy acroeconomic equilibrium at pe hifts the short-run aggregate supply curve S.. Based on the diagram, answer the foll answer the following LRAS Aggregate price SRASZ level SRAS .. AD1 Real GDP a. How do the aggregate price level and aggregate output change in the short run as a result of the oil shock? What is this phenomenon known as? b. What fiscal or monetary policies can the govern- ment use to address the effects of the supply shock? Use a diagram that shows the effect of policies cho- sen to address the change in real GDP. Use another diagram to show the effect of policies chosen to dress the change in the aggregate price level. O supply shocks present a dilemma for govern c. Why do supply sh ment policy makers?

Answer 1

A. The increasing price of oil will result in decrease in GDP. That will increase unemployment. The aggregate price level will also increase.

This is known as stagflation and is an inflation issue.

B. The government has two options. It can either increase the real GDP to previous level, or lower the price level, but it cant do both. This is shown in the graph below.

LRAS Aggregate price level SRASZ SRAS P2 AD2 Real GDP

The government can increase its spending to increase GDP, but that will drive prices higher. It can otherwise reduce its spending, increase taxes etc- resulting in lower output but same price.

C. These are considered dilemmas because, as discussed above, in case of supply shocks- the government can only solve one issue- price or GDP, at one time. In fact, solving for one usually makes the other even worse.