Question

9. Using the AS/AD model, show the effect of a major, temporary increase in oil prices when firms and consumers have rational expectations such that . Describe the process of returning to the steady state

Answer 1

An increase in the price of oil decrease output and increases prices in the short run.

Before the increase in the price of oil, the aggregate supply curve goes through point A, where output equals Y_n and the price level is equal to P^e. After the increase in price of oil, The new aggregate supply curve goes through point B, where output equals the new lower natural level of output Y_n' and the price level equals the expected price level, P^e. The aggregate supply curve shifts left from AS to AS'.Over time, the economy moves along the aggregate demand curve from A' to A''. At point A", output Y' is equal to the new lower natural level of output Y_n', and the price level is higher than before the oil shock.

AS price level, p Yn Y Yn output, y