Question

(14p) COUNTRY A: Utilizing the results that you have obtained from wage-setting/price-setting labor market relationships use IS/LM/PC relationship and graphs and show the effects of the rise in oil prices and subsequent labor market policy changes on the economy of Country A. In your answer, explain the changes in the unemployment rate, real wages, price level, and output: i. immediately after the oil price shock; and ii. after the labor market policy change, i.e. the final medium-run equilibrium.

Answer 1

Ans) The immediate effect of increase in oil price will increase the output of the product as suppliers will supply quantity proportional to the price i.e the increase in price will motivate suppliers to produce more to earn more profit. The cost of production will increase because of increase in price of oil. This will shift the IS curve to the right hand side showing the increase in output with the increase in price. As we that there is inverse relation between unemployment rate and inflation so the increase in inflation will decrease unemployment rate as a result the income of the workers will increase. The income will shift from y to y', in short run. The equilibrium point will shift from E to E' as shown in diagram. But the government will intervene in this economy to stabilization the price or inflation in the economy as they can't let the price increase of oil or oil products. So the govt will intervene by using monetary policy by increasing money supply in the economy to meet the demand for money. The demand of money has been increased because of increase in output and income as discussed above so in medium run the supply curve will shift the LM curve to right hand side i.e to LM'. This will reduce the price of oil to some extent as in figure from P' to P".

Ew we o

The equilibrium point will move from E' to E" in long run in this economy. As a result the output will increase to further as the demand of the product has increased as well as income of the consumer has been increased. In long run the price will between the initial price and new price.