Supply shocks and demand management
Assume that the economy starts at the natural level of output. Now suppose there is an increase in the price of oil.
a. In an AS-AD diagram, show what happens to output and the price level in the short run and the medium run.
b. What happens to the unemployment rate in the short run? in the medium run?
Suppose that the Federal Reserve decides to respond immediately to the increase in the price of oil. In particular, suppose that the Fed wants to prevent the unemployment rate from changing in the short run after the increase in the price of oil. Assume that the Fed changes the money supply once-immediately after the increase in the price of oil-and then does not change the money supply again.
c. What should the Fed do to prevent the unemployment rate from changing in the short run? Show how the Fed's action, combined with the decline in business confidence, affects the AS-AD diagram in the short run and the medium run.
d. How do output and the price level in the short run and the medium run compare to your answers from part (a)?
e. How do the short-run and medium-run unemployment rates compare to your answers from part (b)?