Question: An oil price shock (hard): Suppose the economy is hit by an unexpected oil price shock that permanently raises oil prices by $50 per barrel. This is a temporary increase in o¯ in the model: the shock o¯ becomes positive for one period and then goes back to zero.
(a) Using the full short-run model, explain what happens to the economy in the absence of any monetary policy action. Be sure to include graphs showing how output and inflation respond over time.
(b) Suppose you are in charge of the central bank. What monetary policy action would you take and why? Using the short-run model, explain what would happen to the economy in this case. Compare your graphs of output and inflation with those from part (a).