Question

Briefly describe what happens to GDP and inflation during an oil shock. Given the Fed’s two goals, why does an oil shock create a dilemma for the Fed? What is their most likely policy response (i.e. change in money supply/interest rate/open market operation)?

Answer 1

An negative oil price shock generally increases the cost of production for most of the industries because the energy requirement is fulfilled by oil. this reduces production and the short run aggregate supply curve shifts to the left. Real GDP is reduced and inflation is dramatically increased

The two goals of the federal reserve Bank is to ensure maximum employment which is done via maximizing GDP and maintain prices stability which is done via lower rate of inflation

In the case of a negative supply shock, both of these goals are not achieved at the same time since, monetary expansion will increase GDP but will increase inflation as well. And that monetary contraction will reduce inflation but will reduce GDP as well.

it will then be a trade-off between high inflation or high GDP that the federal reserve will be looking at. If the federal reserve is more careful towards inflation then it will use monetary contraction, and will decrease money supply. Is the federal reserve is more careful towards real GDP, then it will use monetary expansion and increase money supply.