Suppose the economy is in the long-run equilibrium.
a. Draw a diagram to illustrate the state of the economy. Be sure to show aggregate demand, short-run aggregate supply, and long-run aggregate supply.
b. Now suppose war in the world's main oil-producing region sharply reduces the world oil supply, causing oil prices to rise and increasing the costs of producing goods and services in this economy. Use your diagram to show what happens to output and the price level in the short run.
c. Use the sticky-wage theory of aggregate supply to explain what will happen to output and the price level in the long run (assuming there are no policy changes). What role does the expected price level play in this adjustment? Be sure to illustrate your analysis in a graph.