1. Suppose the economy is hit by an unexpected oil price shock that permanently raises oil prices by $50 per barrel. (This is a temporary increase in o¯ in the model: the shock o¯ becomes positive for one period and then goes back to zero.)
(a) Using the full short-run model, explain what happens to the economy in the absence of any monetary policy action.
i. How does the Phillips curve change? What happens to output and inflation?
ii. How does the IS curve change? What happens output and real interest rates?
iii. How does the MP curve change?
(b) Suppose you are in charge of the Federal Reserve. What monetary policy action would you take and why? Using the short-run model, explain what would happen to the economy in this case.
Initially, at equilibrium, the level of output is at natural level Yn and price level is equal to the expected price level i.e. P1 = P1e (point1). With the oil price shock, LM curve shifts upwards from LM1 to LM2. The level of output falls from natural level of output Yn to Y2.
The AD relation is given by
Y = Y (M/P, G, T)
With price shock, AD curve falls downwards from AD1 to AD2. At point 2, the level of price P2 is less than expected price level. This leads to a revision in the level of expected price downwards.
b) A mometary policy action of increase in supply of moey can be taken in the economy. LM curve will shift rightwards. As a result, the aggregate demand curve shifts rightwards from AD2 to AD1 and output returns back to the natural level.
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