Question

Suppose that a permanent increase in oil prices both creates and inflationary shock and reduces potential output. Using the AD-AS diagram to show the effects in the short run and long run (two separate diagrams) assuming there is no policy response? Then what happens if the reserve bank responds to the oil price by tightening monetary policy?

Answer 1

If there is a oil shock then raw material prices will increase and so this will cause the AS curve to shift leftwards. This will cause the price level to rise and also the output level to fall below the potential output level, assuming that we were initially at long run equilibrium. On its own the economy will return to long run equilibrium over time but at a higher level of prices. The economy will thus move from A to B in the long run. This is assuming no policy response. If the reserve bank tightens monetary policy on top of this then this would mean that aggregate demand will fall and so the AD curve shifts leftwards which brings down the price level but at the same time worsens the output level further below the level of potential output. The first diagram below thus shows the supply shock as the AS curve shifts leftwards and moves to A. The second diagram shows the economy moves to B in long run equilibrium. The third diagram shows the leftward shift of the AD curve as prices fall but so does output.