Question

There is a decrease in oil prices, and everyone believes this decline in oil prices is temporary. You attend a meeting at the Bank of Canada and hear that their analyst suggests, "Low oil prices increase the aggregate demand, and we face a real possibility of increased inflation. To prevent undesirable inflation, we must reduce the money supply." Using the AD-AS model, analyze the analyst’s proposal, i.e., explain whether and why his proposal would prevent undesirable inflation (achieve price stability).

Answer 1

Low oil price will raise aggregate demand of all goods because consumers will be left with more income to spend on goods. Rise in aggregate demand will shift AD curve to its right from AD to AD1 which will cause price to rise from P to P1 while output fall from Y to Y1.

To prevente undesirable inflation, reduction money supply will reduce cash holdings with people and tends to reduce their willingness to pay for goods which will ultimately not shift aggregate demand curve and hence inflation.