Question

Q.2 AD-AS model analysis for an increase in oil price

• Start with an initial AD-AS model with full employment equilibrium. Please label all the axes and the curves. Label the equilibrium as “1”.

• Let’s say that there is an oil shock (the price of oil has increased). What happens to which curve? Make sure to show the changes in the above AD-AS model. Therefore, what happens to the equilibrium and the economic condition? Explain all the changes in writing as well.

• What do we call this economic status? Explain how this economic situation is not the same as the recession in general.

Answer 1

At equilibrium 1, there is an initial AD-AS model with full employment equilibrium. AD and AS meet at 1 to determine long run price level Pf and real GDP Yf.

There is an oil shock where the price of oil has increased. This implies that the cost of producing goods and services has increased. This will reduce production and so AS shifts left. This is shown in the AD-AS model as a movement from equilibrium 1 to equilibrium 2 where the equilibrium price is now increased to P1 and real GDP has reduced to Y1. This economic condition is shown by a negative output gap called the recessionary gap

We can call this economic status is stagflation. This is not the same as the recession in general because in general price level is decreasing and we experience deflation. But here we experience rising price levels and so there is an inflation coupled with high unemployment.