Question

1.Consider the monetary intertemporal model as discussed in the course. There is no inflation. Suppose that the price of oil, an important input in production, doubles. Now suppose that nominal wages are sticky. Initially, the economy is at full employment.

a) Derive the effect of the oil price shock in the Keynesian framework.

b) What should the central bank do if its objective is to stabilize prices and what should it do if its objective is to speed up the adjustment of employment to its long run level?

(Note to expert: Please answer both a and b as they are both part of the same question, thanks!)

Answer 1

A.This paper studies the impact of a change in real oil prices on output and inflation during a New Keynesian model of the U.S. economy. The main goal of the analysis is to assess whether the cross-equation restrictions imposed by the model play a role in the transmission mechanism of exogenous oil price shocks and the New Keynesian framework states the interactions between oil prices, domestic variables, and expectations generate responses that are quite modest, which can depart from those emerging from a more unrestricted SVAR model. I also find that changes in oil prices that cannot be predicted based on the available information are, for the most part, exogenous to the U.S. economy. As such, augmenting the model to account for their possible endogeneity does not deliver substantially different results.The economic implications of oil price shocks have been extensively studied since the 1970s. Moreover, the Bayesian estimation of the model on the US economy (1984–2007) suggests that the output elasticity of oil may need been above 10%, stressing the role of oil use in US growth at this time.

B.The usual goals of monetary policy are to realize or maintain financial condition , to realize or maintain a high rate of economic process , and to stabilize prices and wages. ... The Fed uses three main instruments in regulating the cash supply: open-market operations, the discount rate, and reserve requirements.
Fiscal policy (cutting taxes and/or increasing spending) can lead to an increase in AD and rise in real GDP. The increase in economic growth will cause increased demand for workers, providing employment and reducing unemployment.If there is an increase in aggregate demand, the price level will go up. Once wages have adjusted thereto inflation within the end of the day , SRAS decreases and returns the economy to financial condition output. Shocks don't cause economic process , only changes fully employment output cause economic process .