Question

Suppose that oil prices sharply increased for a while, which increased production costs, causing an adverse supply shock.

A. Use the AD-AS model to show the effects on output and the price level (inflation) in both the short-run and long-run.

B. Show the adjustment process of the economy from the short-run to the long-run.

C. What is the effect on unemployment in short run and long run?

D. Can policymakers do something to accommodate this shock, such as using monetary policy? Would the outcome be different in this case than self-correction? Please explain.

Answer 1

An adverse supply shock decreases aggregate production.

A. In the goods market with AD-AS model, this implies a leftward shift of the aggregate supply (AS) curve in the short run. This results in inflation in the short run and a recessionary gap because real GDP declines. This condition is called stagflation: high inflation and unemployment and slow GDP growth rate.

In the long run as wages and prices adjust, production cost declines and this raises production. Aggregate supply increases and AS curve shifts right in the long run. Inflation declines and real GDP is back to its long run level. GDP gap is eliminated.

B. The adjustment process of the economy from the short-run to the long-run has short run AS shifting to the right, where both the price level and real GDP are back to their initial values.

C.Unemployment rate exceeds its natural rate in short run thereby causing high unemployment. In long run it returns to its natural rate.

D. Policymakers can stimulate the aggregate demand to accommodate this shock in the short run. If monetary policy is used, central bank has to reduce discount rate, reserve requirement or buy securities in open market to raise money supply. This would decrease rate of interest, raise investment and consumption and consequently shift AD to the right. In the process, there is a further high inflation but GDP gap is eliminated.