Question

Suppose that there is a fall in oil prices. Use the Phillips curve and/or the AD-AS model to show the short run effects on the economy. State clearly what happens to inflation and unemployment. Why does this pose a challenge for the Fed?

Answer 1

A change in Oil prices has a great impact on the economy. A fall in oil prices will decrease the cost of production of the firms and hence the aggregate supply of goods and services will rise in the economy. This increase in supply of goods and services will shift the AS curve rightward, and hence the Price level will come down from P to P1 and the National Income will rise from Y to Y1. This is shown below-

This decrease in price level will bring the rate of inflation down and will increase the unemployment level. This is derived from the Phillips Curve ( which shows relationship between Inflation and unemployment) as shown below -

The Phillips Curve shows an inverse relation between Inflation and Unemployment.

So due to a decrease in oil prices, there is increase in AS, which leads to decrease in Price level, which decreases rate of inflation and hence due to decrease in rate of inflation, the level of Unemployment raises in the economy.

Decreasing rate if inflation and increasing Unemployment is a challenge for Fed because the Fed is concerned that low inflation will cause expectations for inflation to fall even further.That would make it more difficult for the Fed to step in and cut interest rates in an effort to push inflation higher, leading to a deflationary environment.