Question

4. The text notes that changes in oil prices can affect the inflation-unemployment outcome. Explain what effect changes in oil prices may have on these two variables. (with graph)

Answer 1

Increases in the oil prices causes inflation in an economy to rise. As oil is used as a factor of production for several goods or services, it causes their cost of production to increase, which in turn is reflected in the higher prices charged for these goods. Inflation is the measure of the rate of change in the price level of a basket of goods and services.

Unemployment is negatively related with inflation, as modeled by the Philips Curve. Given by A.W. Phillips, the Phillips Curve shows that there exist an inverse relationship between the rate of unemployment and the rate of increase in nominal wages. It says that there is a trade-off between inflation and the unemployment rate. If the inflation rate is increasing, the unemployment rate in the economy would be decreasing.

Date ol Rate of inflation (%) High Inflation is associated with low unemployment. Phillips Curve When oil price rises, for eg., foll the inflation uises from 2% to 6%. I The couresponding unemployment hele decreases from 4% to 2% o n w dit 1 2 3 4 5 Unemployment Rate V.)