Question

2. Use the IS-LM model to analyze the general equilib- rium effects of a permanent increase in the price of oil (a permanent adverse supply shock) on current out- put, employment, the real wage, national saving, con- sumption, investment, the real interest rate, and the price level. Assume that, besides reducing the current productivity of capital and labor, the permanent sup- ply shock lowers both the expected future MPK and households' expected future incomes. (Assume that the rightward shift in labor supply is smaller than the leftward shift in labor demand.) Show that, if the real interest rate rises at all, it will rise less than in the case of a temporary supply shock that has an equal effect on current output.

Answer 1

Answer:

A permanent increase in the price of oil i.e. a permanent adverse supply shock will reduce the marginal product of labor, leading to a leftward shift in the demand for labor curve. As both full employment output and productivity falls, the FE line shifts to the left. Since the output falls, firms will raise their prices in order to equate the demand with reduced supply. With a fall in prices, the real supply of money falls and shifts the LM curve to the right. Since in the given case the supply shock is permanent and the future marginal product of capital falls, the IS curve will also shift to the left, so that the rise in the real interest rate is less than in case of a temporary shock. All this can be seen graphically as:

FE FE LM' WI/ SI SI Y2Y1

The new equilibrium point is C. Net Result: Future output falls Consumption falls Real wage falls Price level increases Real interest rate net effect is ambiguous (Depends on the magnitude of shifts) Savings and investment net effect is ambiguous. The price level will increase and shift the LM curve upward to pass through the new equilibrium point. The result is an increase in the price level, but an ambiguous effect on the real interest rate.

Assume that reducing the current productivity of capital and labor, the permanent supply shock lower both the expected future MPK and households expected future income. Real wages § ND2 \ND N2 Ni Units of labor Effects of adverse supply shock on the Labor Market