Question

Use the AD/AS model to analyze the general equilibrium effects of a permanent increase in the price of oil (a permanent adverse supply shock) on current output, employment, and the real interest rate.

Answer 1

Effect: Permanent increase in price of oil

Initial equilibrium occurs when demand equals supply and equilibrium point occurs at point A. When there is adverse supply shock, it will cause supply curve of oil shifts to its left from point AS to AS1 which takes economic equilibrium from point A to B. It will reduce the output level from point Q* To Q1 and raise prices from P* to P1 in short run. In long run, as prices rises, people will reduce their demand and shift the demand curve to its left which will reduce price again to its initial level and reduce output level further to Q2.

Aggregate demand = Consumption + Investment + Government spending + Exports - Imports

When price of oil rises, consumers real disposable income falls which will reduce the consumption of oil as well as aggregate demand in an economy. It will shift the IS curve to its left from IS to IS1.

As this is a permanent oil supply shock, there is reduction in real money supply in an economy which shifts LM curve to its elft from LM to LM1. In long run equilibrium shifts from point A to C.

Thus we can say that, output level falls from Y* to Y2 in long run. As output level fell, less people would be needed to produce goods which will reduce the employment level. Interest rate in long run will remains the same while in short run it might fall.