Question

Assume that the economy is beginning at equilibrium. There is a supply shock and OPEC has decided to lower production, which raises the price of oil worldwide. What will happen to the price level and RGDP in the short-run? Label the original point (A) and the new point after the shift as (B) Assume that the price level is flexible downwards as well as upwards. (3) b) Assume that the government in reaction assumes a Classical stance and does not introduce a policy shift. What happens to the economy in the long run according to Classical economists? Graph this shift and explain the process. (3) c) However, you are a Keynesian economist and therefore prepare a critique of this Classical stance. What is the resulting change in prices and RGDP from this laissez-faire stance? Label this point as (C). What instead would you propose as a necessary policy shift? Why? Describe and graph each step. (5)

Answer 1

With oil shock aggregate demand shifted leftwards from AD1 to ADo. As a result economy moves from A to c. Both prices and gdp fall

According to classicals in the longrun wages will also fall because due to lower prices purchasing power of labour has risen. Thus supply will increase from SRAS 1 to SRAS 2. Thus full employment gdp is restored back with lower prices

With laissez faire policy Aggregate demand falls and new equilbrium is at c. The result is Lower gdp and prices. Thus there is recession. (Keynesnias)

To counter this govt should raise aggregate demand back to AD1 through fiscal policy i. E by greater expenditure.