Answer to Question #138114 in Macroeconomics for EBENEZER

Question

Using an IS-LM model, AD-AS model, and a Phillips curve, explain the impact of an increase in oil prices on the economy. Analyse the short run impact on real output, employment, prices, and real interest rates. Be sure to explain how it is possible to have an increase in the rate of unemployment while simultaneously experiencing an increase in inflation. Suppose that this increase in oil prices was permanent. What are the long run effects on the economy?

Answer 1

Solution

If there is increment in the price of oil it means that aggregate demand of oil is increased. there is an increase in aggregate demand, so during demand-pull inflation, there will be an upward movement along the Phillips curve. As aggregate demand increases, real GDP and price level increase, which lowers the unemployment rate and increases inflation.

it is possible to have an increase in the rate of unemployment while simultaneously experiencing an increase in inflation.classical phillips curve was unable to explain it so NAIRU theory was used ito explain it. that is-

the simultaneously high rates of unemployment and inflation could be explained because workers changed their inflation expectations, shifting the short-run Phillips curve, and increasing the prevailing rate of inflation in the economy.

The IS relationship and LM relationship create opposing forces. On the one hand, a falling interest rate tends to cause the economy to expand. On the other hand, an expanding economy causes interest rates to rise. Where the two curves meet, the forces are balanced and the economy is in equilibrium.