Oil Price Shocks Both the long-run aggregate supply curve and the short-run aggr

Question

Oil Price Shocks

Both the long-run aggregate supply curve and the short-run aggregate supply curve shift in response to changes in the availability of labor or capital or to changes in technology and productivity. A widespread temporary change in the prices of factors of production, however, can cause a shift in the short-run aggregate supply curve without affecting the long-run aggregate supply curve.

Tasks:
Suppose there is a temporary but significant increase in oil prices in an economy with an upward-sloping Short-Run Aggregate Supply (SRAS) curve. If policymakers wish to prevent the equilibrium price level from changing in response to the oil price increase, should they increase or decrease the quantity of money in circulation? Why?

Explanation / Answer

Neither. It isn't possible.

On the one hand you are saying "temporary" which means short term, yet you are talking about longer term changes.

It takes time for a money supply change to be reflected in prices - prices and wages are sticky!


If you are looking for a long term equilibrium price level, then decreasing the money supply would be the way to go, but then you really end up with deflation once theoil priceschange back.

What you are really talking about is a cost-push inflation, which no one really knows how to deal with:

Milton Friedman argued that the government should keep the money supply constant to prevent inflation. But since more of the constant money goes to oil, less would have to go to other goods. Lower demand means a recession, fewer returns to scale, less money circulating, etc. All in all, not a stable situation. And Milton Friedman's Monetarism has been discredited.

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