Question

It is 1979 and there is a sudden decline in oil supplies due to political turmoil in the Middle East which sends the price of crude oil skyrocketing. Assume that the US economy is initially operating at its potential level output (hint: this means that the US economy is both at its short and long run equilibrium).

a) What will this event cause in terms of the equilibrium price level and output? How about the rate of unemployment?

b) You are the chairman of the Fed and therefore you need to respond with a change in monetary policy in order to tackle the issues discovered at point a). What could you propose and what are the tradeoffs?

Your answers should be based on the use of the AS-AD model. Explain which curves are shifting and in what direction.

Answer 1

a) An increase in the oil prices which is the input of the industries will lead to a higher input price of the goods. This will force the aggregate supply curve to move to the left i.e. at a higher price and lower output. At a higher price, the demand will decrease and the unemployment will increase with the decreasing output.

b) As a chairman of the Fed, I would recommend an easy monetary policy i.e. decrease the interest rate. It will further shift the aggregate demand curve to the right at an even higher price and larger output but it will decrease the unemployment in the economy. The purchasing power of the economy will be reduced at the current value of the currency affecting the fixed income people. But that the only way possible, if the rates are increases it will decrease the demand even further and raise the unemployment and reduce the output.