Question

Suppose that a permanent decrease in oil prices both creates and inflationary shock and increases potential output. Use an AD-AS diagram to show the effects of the oil price decrease on output and inflation in the short run and long run given that the RBA can only move along the PRF. Explain how there is no longer a short run or long run outcome that results and how what happens depends on the relative size of the shift in potential output and the shift in AS

Answer 1

1. A reduction in taxes increases consumer spending and hence aggregate demand. The graph and the results in the short run and the long run are the same as in part a.

2. An easing of monetary policy lowers the real interest rate set by the Reserve Bank at each level of inflation. The aggregate demand curve shifts right. The graph and results are the same as in part a.

3. A sharp drop in oil prices is a favourable inflation shock. The SRAS line shifts downward, reducing inflation and raising output. If potential output is unchanged, an expansionary gap exists and inflation will begin to rise. In the long run the economy returns to output and inflation as originally.

4. Increased government purchases raise aggregate demand and shift the AD curve right. The graph and results are the same as in part a.