Oil prices rose nearly 5 percent over the past week on expectations U.S. crude inventories have dropped and on signs that the world's top oil exporters will stick to agreed output cuts that took effect last week. Assume that the Australian economy starts at the natural level of output and suppose that this is a temporary increase in the relative price of oil, lasting 3 years:
a) Using the wage-setting and price-setting diagram (explaining the intuition behind the curves), show what happens to the unemployment rate in the medium run.
b) In an AS-AD diagram (explaining what lies behind the aggregate supply and demand curves) explain the effect on short-run output.
c) Assume the central bank has a price level target for goods, show what happens to output and the price level in the medium run.
d) How would your answers in (b) and (c) change for an economy experiencing the liquidity trap problem. Give an explanation for the slopes and positions of the IS-LM and AD-AS curves in the diagram.