Use the classical (RBC) IS-LM-FE model to show the effects on the economy of a temporary...

Use the classical (RBC) IS-LM-FE model to show the effects on the economy of a temporary adverse supply shock; for example, an increase in the price of oil. You should show the impact on the real wage, employment, output, the real interest rate, consumption, investment, and the price level.

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Expert Solution

Let us begin at initial equilibrium, as shown below.

The economy is in full employment output Y1, the IS curve, LM curve and output FE line are all intersecting at equilibrium point E.

Now, a temporary supply shock happens. Lets see what happens with the help of the graph below.

The supply shock results in reduction of full employment output to Y2. The new equilibrium point is now F, where the the FE line intersects with the IS curve. The price increases, resulting in the LM curve movement along the IS curve to LM2 until reaching point F.

At this new stage, output is lower, real interest rate is higher, price is higher, it has no impact on demand or supply of money, consumption is lower, investment is lower, real wages are lower, employment is lower, inflation is higher.

Rahul Sunny answered 2 months ago

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