Assume that the economy starts at the natural level of output. Now suppose there

Question

Assume that the economy starts at the natural level of output. Now suppose there is a decrease in the price of price of oil.
a): Using an AD-AS diagram, describe what happens to output, unemployment and price level in the short run and in the medium run.

Suppose now, that the RBA decides to respond immediately to the decrease in 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 oil price.

b): 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 oil price, affects the AS-AD diagram in the short run and the medium run.
c): How do output, unemployment and price level in the short run and the medium run compare with your answers from part (a)?

Explanation / Answer

a) For this part, think about how a change in the price of oil would affect the aggregate supply and demand within the economy. Would it have an effect on AD, LRAS, or SRAS? Once you've decided that, draw the shift on the curves as appropriate. b) Look at the new equilibrium after you've shifted the curves. How has the price level changed in the economy? Consider how changes in the price level affect unemployment. Discuss the monetary policy that the RBA could implement to mitigate the change in the price level. Draw the offset between the oil price change and the monetary measures on your graph. c) Once you've finished B, just look at the changes on your graph and compare it with (a).

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