Question

Suppose an oil-importing economy is in long-run equilibrium. Organization of petroleum exporting countries decides to reduce oil production causing oil price to soar.

b. To stabilize price in short-run, should Central bank decrease discount rate?

c. If policymakers do nothing, please show the new long run equilibrium. What causes the economy to move from short run to long run equilibrium?

Please answer both if possible, thank you so much.

Answer 1

b)suppose as the oil price hike leads to inflation in the oil importing country but central bank can take some measures to stabilize the price level.now if central bank decreases the discount rate then the rate of interest may fall as commercial bank can lend money from the central bank at lower interest rate.so they want to give more loans than before.it could be a good measure if the country suffers from deflation but is there any effect of decrease the discount rate at the time of inflation,lets see.as the oil price increases the all esential goods price will rise.now after the decrease in discount rate inveators want to invest more by taking loans as now the profitability of capital increases due to decrease in interest rate.so as new industries will establish it is for sure the total output will increase and central bank may think that if the total output increases that leads the price to the downward direction as there is excess supply over demand.but this may not happen in real.in real life as discount rate decreases and banks give more loans than before it will increase the money supply of the economy.and as money supply increases all individual holds more money than before.and as they holds more money now they are willing to pay for the same products than before.so it will increase the price level of the country and the objective of the central bank to stabilize price in short run may fail.

c)now if the oil price hike is occur and policy maker dosen't take any steps then what should be the scenario.lets see it if the oil price hike occurs then the transportaion cost will increase.and as transport cost increases all goods price will rise.and now as price level increases with all the individuals income remaining same so their actual income decreases.that means with the same amount of money individuals will get less products than before.so the aggregate demand will decrease in the short run.and as demand decreases firms wants to decrease the production.but in the long run workers will realise firms are getting abnormal profit so they want higher wage rate and the producer has to increase the wage rate.so the abnormal profit of producer will abolish as worker will calculate the rise in price lavel and demand the smae amount of wage increase.so now the wage rate increases at the same proportion to.the price level it means the actual income of the workers will restore at the initial level. in this situation the long run achived where the total output of the economy will be the same only the price level is higher than the initial.