Question

Assume that the economy is at long run equilibrium,with unemplyment at 5% and inflation at 2%pa.

Suppose a shock causes a very large increase in the cost of crude oil and gas. Assume that Ireland does not produce any oil or gas, and imports large amounts of oil and gas. The shock causes unemployment to rise to 9%, and inflation to rise to 4%pa.

(a) Using a large AD/AS diagram and a large Phillips curve diagram, illustrate the short-run effects of this shock on the Irish economy.

[assume that the oil cost shock causes v= 4%, that the price level is not sticky, and that beta symbol= 0.5 in the Phillips curve equation]

(b) Describe and illustrate a policy response that might help return the economy to its long-run equilibrium.

Answer 1

Supply side shock will shift aggregate supply to the left and philips curve will shift outwards showing more inflation rate and more unemployment rate.

Aggregate supply shifts from AS1 to AS2 and hence inflation-unemployment in Philips curve which was 2% and 5 % respectively will shift outwards from Short run Philips curve (SRPC) to new SRP with more inflation and unemployment- say 4% and 9% respectively. In short from point a to point b in Philips curve diagram. This has happened as price levels went from P1 to P2 and real GDP shifted from Y1 to Y2 causing unemployment to go up.

This shows stagflation in the short run.

b. Policies should focus on supply side.

Supply side policies: This policy focuses on aggregate supply. It has two types- market based and interventionist based. market based policy focuses on incentives for businesses, labor market reforms and encouraging competition. Interventionist based policy focuses on human and physical capital.

All these factors will aim at shifting aggregate supply back to AS1 . This needs a longer time and a country should focus on developing oil alternatives. This will bring AS2 back to AS1 and Long run Philips curve is regained with Short run Philips curve shifting back from point b to point a.