Question

Recently oil prices have fallen. Assume the economy is at full employment output. Treat this decline as a negative shock to production. Graph the change to the production function.

Graph the short run effect on the demand for labor.

Show the effect on the IS LM relationship in a graph. Is the change in output permanent or temporary?

Answer 1

(I) The negative shock to production will decrease productivity and output, shifting production function downward from Y0 to Y1 as shown below.

(II) Lower output will reduce demand for labor, decreasing both wage rate and employment.

In following graph, D0 and S0 are initial labor demand and supply curves intersecting at point A with initial wage rate P0 and employment Q0. Lower labor demand will shift D0 leftward to D1, intersecting S0 at point B with lower wage rate P1 and lower employment Q1.

3 9.

(III) Lower production will shift IS curve leftward, decreasing both interest rate and output.

In following graph, IS0 and LM0 are initial IS and LM curves intersecting at point A with initial interest rate r0 and output Y0. Lower production will shift IS0 leftward to IS1, intersecting LM0 at point B with lower interest rate r1 and lower output Y1.

LMO 15 ч. Yо у

(IV) This will be a temporary shock to production and output.