Question

Please provide graphs:

Briefly describe what happens to GDP and inflation during an oil shock. Given the Fed’s two goals, why does an oil shock create a dilemma for the Fed? What is their most likely policy response (i.e. change in money supply/interest rate/open market operation)?

Answer 1

Oil shock causes stagflation or stagnation and inflation. Increase in oil price pushes up cost of production. So, producers are compelled to shift supply curve to left. it will pull down output level and price shall be increased.

GDP falls and inflation rises. Graph is as follows:

SRAS 2 PL SRAS 1 AD Real GDP (Y) Y2 Y1

In above diagram, increase in oil price shifts the AS to left, thereby pulling down Real GDP and pushing up inflation rate.

Fed has been mandated to achieve twin objectives: price stability and full employment. If Fed wants to reduce price level, it must be reducing AD and that will further kill real GDP and employments. Further, if Fed increases demand to deal with problem of deficient demand in market, price will shoot up further.

Thus, usually Fed will go with output and employments in short run. it will increase demand to keep the unemployment level minimum.