Question

Using the AD-AS graph and the IS-LM graph, illustrate and explain the short-run and medium-run effects of a reduction in the price of oil. Explain what happens to the price level, output, real wage, investment, and unemployment.

Answer 1

Ans. Decrease in price of oil leads to decrease in cost of production, this increases aggregate supply shifting the aggregate supply curve from AS to AS'. This leads to a situation of excess supply of goods and services decreasing the price level from P to P'. This decrease in price level increases the real money supply for given nominal money supply. This shifts the LM curve rightwards from LM to LM' This decreases the interest rate from r to r' reducing cost of borrowing which induces investment increasing output level from Y to Y' and as output has increased, unemployment rate also falls.

In medium run, the lower price level means the real wages of the labor has increased which means that firms are paying higher real wages increasing the cost of production causing decrease in aggregate supply shifting the curve back to AS'. Which increases the proce level back to P and because peice is back to the initial level, the real money supply decreases to initial level shifting LM curve back to the original position decreasing output level back to full employment and interest rate back to r from r'. Now that every variable is back to its original position, investment and unemployment rate also move back to the original position in medium run.

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