Supply shocks and demand management Assume that the economy...

Supply shocks and demand management Assume that the economy starts at the natural level of output. Now suppose there is a decrease in the price of oil. a. In an $A S-A D$ 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 RBA decides to respond immediately to the decrease in the price of oil. In particular, suppose that the RBA wants to prevent the unemployment rate from changing in the short run, after the decrease in the price of oil. c. What should the RBA do to prevent the unemployment rate from changing in the short run? Show how the RBA's action, combined with the decrease in the price of oil, affects the $A S-A D$ diagram in the short run and 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)?

Supply shocks and demand management
Assume that the economy starts at the natural level of output. Now suppose there is a decrease in the price of oil.
a. In an $A S-A D$ 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 RBA decides to respond immediately to the decrease in the price of oil. In particular, suppose that the RBA wants to prevent the unemployment rate from changing in the short run, after the decrease in the price of oil.
c. What should the RBA do to prevent the unemployment rate from changing in the short run? Show how the RBA's action, combined with the decrease in the price of oil, affects the $A S-A D$ diagram in the short run and 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)?

Key Concepts

Demand Management and Monetary Policy

Demand management involves using fiscal and monetary policy tools to influence aggregate demand in the economy with the aim of stabilizing output and employment. Monetary policy, specifically, uses interest rate adjustments and other mechanisms by the central bank to counteract economic fluctuations, such as those induced by supply shocks, to maintain stability in key indicators like the unemployment rate.

Unemployment and the Natural Rate

The natural rate of unemployment reflects the level of unemployment consistent with long-run equilibrium when the economy operates at its natural level of output. In the short run, due to price and wage rigidity, deviations from this natural rate can occur. However, as adjustments occur in the medium run, the unemployment rate is expected to return to its natural level.

Supply Shocks

Supply shocks are unexpected events that suddenly change the production capacity or production costs of an economy. They can be positive or negative and shift the aggregate supply curve. Positive supply shocks, such as a decrease in input prices, typically increase output and lower the price level in the short run, while negative shocks have the opposite effect.

Short-Run versus Medium-Run Adjustments

In macroeconomics, the short run is a period during which some prices and wages are sticky, meaning they do not adjust immediately to changes in economic conditions, leading to temporary deviations from the natural level of output. In the medium run, however, prices and wages adjust fully, which brings output back to its natural level, even as the price level may differ from its initial state.

Aggregate Supply and Aggregate Demand (AS-AD) Framework

This concept refers to a macroeconomic model that illustrates how the total output (real GDP) and the overall price level in an economy are determined through the interaction of aggregate supply (AS) and aggregate demand (AD). It provides a useful tool to analyze the effects of various shocks, including those affecting supply or demand, and to understand the short-run and medium-run adjustments in an economy.

Transcript

00:01 Moving on to question four, suppose the economy is in a long run equilibrium.

00:06 Part a, draw the economy short run and long run phillips curves.

00:10 Well, that shouldn't be very difficult because we've done it a couple times now.

00:15 So here on the left, i've drawn a very simple standard graph.

00:18 On the x -axis, we have the unemployment level u.

00:21 On the y -axis, we have the inflation rate pi.

00:24 As always, the long -run phillips curve will be vertical and intersect the x -axis at the natural level of unemployment u1.

00:31 And of course the downward sloping, short on the phillips curve, will dissect the longer phillips curve at point a, which is where the economy is at since we're in the long -run equilibrium.

00:45 And at point a, the natural level of unemployment and inflation rate pi -1 prevail.

00:51 Now in part b, suppose a wave of business pessimism reduces aggregate demand, show the effect of this shock on your diagram from part a if the fed undertakes expansionary monetary policy can it return the economy to its original inflation rate and unemployment rate well here we're dealing with negative aggregate demand shock so from what we know from theory the economy will shift along the phillips curve so the phillips curve will not move but the economy will move along from point a to point b since an aggregate demand, so think about the aggregate supply and aggrine demand graph.

01:33 Aggregate demand moves to the left.

01:37 So the new output level will be lower.

01:40 There will be a recessionary gap.

01:42 And here this is reflected with a higher level of unemployment, u2.

01:48 And on the other hand, since the price level drops, we'll also have a lowered level of inflation, pi 2.

01:54 So we're at point b, higher unemployment, lower inflation.

01:59 Now in part c, suppose the economy is back in long islander equilibrium and then the price of imported oil rises.

02:07 Show the effect of this shock with a new diagram and think what happens if the fed undertakes expansionary monetary policy and what happens when the fed undertakes contractionary monetary policy? well, this is even more interesting.

02:22 Now i've redrawn the graph, the same graph on the right.

02:28 And now we know that the economy has been hit by a supply shock, a serious one.

02:34 This is kind of like what happened in the mid -70s and the late 70s, the u .s...

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