Suppose that there is a temporary, but significant,increase in oil prices in an economy with an upward-sloping SRAS curve. If policy makers 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
To determine whether policy makers should increase or decrease the quantity of money in circulation to prevent the equilibrium price level from changing in response to an oil price increase, we need to understand the relationship between money supply, aggregate demand (AD), and the short-run aggregate supply (SRAS) curve.
In an economy with an upward-sloping SRAS curve, an increase in oil prices (a positive supply shock) leads to higher production costs and a decrease in aggregate supply (AS). This shift in AS increases the equilibrium price level and reduces real output, resulting in potential inflationary pressures and a negative impact on the economy.
To counteract these effects and keep the equilibrium price level from changing, policy makers can use monetary policy, specifically adjusting the quantity of money in circulation. The primary tool they have at their disposal is the open market operations (OMOs), where the central bank buys or sells government securities to adjust the money supply.
In this scenario, where oil prices increase temporarily but significantly, policy makers should **increase the quantity of money in circulation** to prevent the equilibrium price level from changing. By increasing the money supply, policy makers can stimulate economic activity and increase aggregate demand. This increase in AD will offset the negative impact on aggregate supply caused by the higher oil prices, allowing the equilibrium price level to remain stable.
Increasing the money supply helps to boost consumer spending, investment, and business activities. The resulting increase in AD shifts the AD curve to the right, intersecting the SRAS curve at the same level of real output as before, thereby keeping the equilibrium price level unchanged.
To summarize, policy makers should increase the quantity of money in circulation to mitigate the negative effects of temporary, significant oil price increases and prevent changes in the equilibrium price level. Increasing the money supply stimulates aggregate demand, counteracting the decrease in aggregate supply caused by higher oil prices.
To prevent the equilibrium price level from changing in response to the temporary increase in oil prices, policy makers should increase the quantity of money in circulation.
By increasing the quantity of money, policy makers can lower interest rates in the economy, which stimulates spending and investment. This increase in spending can help offset the negative effects of the oil price increase on output and employment levels.
When the quantity of money is increased, consumers have more money available to spend, which increases aggregate demand. As a result, businesses have more revenue and are able to maintain their current level of production without increasing prices.
Additionally, the increase in money supply can help stabilize the price level by preventing the decrease in aggregate demand that would have occurred due to the oil price increase. This prevents any downward pressure on prices and ensures that the equilibrium price level remains constant.
Therefore, to prevent the equilibrium price level from changing in response to an increase in oil prices, policy makers should increase the quantity of money in circulation to stimulate spending, investment, and aggregate demand in the economy.