Question

Question 2. An oil cartel effectively increases the price of oil by 100 percent, leading to an adverse supply shock in both Country A and Country B. Both countries were in long-run equilibrium at the same level of output and prices at the time of the shock. The central bank of Country A takes no stabilizing-policy actions. After the short-run impacts of the adverse supply shock become apparent, the central bank of Country B increases the money supply to return the economy to full employment.

a. Describe the short-run and long run impact of the adverse supply shock on prices and output in country A (For full credit, draw a graph showing all terminal equilibrium points and explain).

a. Describe the short-run and long run impact of the adverse supply shock on prices and output in country B (For full credit, draw a graph showing all terminal equilibrium points and explain).

b. Compare the long-run impact of the adverse supply shock on prices and output in the two countries.

Answer 1

Theory:

In the short run: Both countries A and B will have a negative supply side shock. Aggregate supply will shift from AS1 to AS2, average price levels will go up from P1 to P2 and real GDP will shift from Y1 to Y2. This is a stagflation situation in which inflation and unemployment both will be more.

a. Country B will have stagflation as shown in diagram above due to negative supply side shock in the short run.Country B govt. is putting money in an economy which is a part of expansionary fiscal policy. As shown in the diagram below, AS1shifted to left and new equilibrium was set from point a to b. Govt. putting money shifts AD1 o AD2 in the long run bringing economy from Y2 back to Y1 which is LRAS in the long run. Price levels change in this time. However, correcting supply side shock needs more investments in supply side policies.

b. It is likely that country A will be stuck at Y2 level of output as no policy to correct this shock is taken. It is true that price levels will go up and real GDP which is real output will also decrease in the short run and in the long run too price levels will go up.