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?
To determine whether policymakers should increase or decrease the quantity of money in circulation to prevent the equilibrium price level from changing, we need to analyze the relationship between money supply, price level, and aggregate demand.
In an economy with an upward-sloping Short-Run Aggregate Supply (SRAS) curve, an increase in oil prices would typically lead to a higher cost of production for businesses. This can cause a decrease in aggregate supply (AS), leading to a lower level of real output and, potentially, an increase in the price level.
To counteract the impact of the oil price increase and maintain the equilibrium price level, policymakers can consider adjusting the quantity of money in circulation. Given the situation described, they should increase the quantity of money in circulation.
By increasing the money supply, policymakers can effectively increase aggregate demand (AD). An increase in aggregate demand can help offset the decrease in aggregate supply caused by the higher oil prices. This increase in aggregate demand can help maintain output levels and prevent a significant increase in the equilibrium price level.
Increasing the quantity of money in circulation can be achieved through monetary policy tools. Central banks, such as the Federal Reserve in the United States, have the authority to implement contractionary or expansionary monetary policies, which affect the overall money supply. To increase the quantity of money, policymakers can engage in expansionary monetary policy by lowering interest rates, buying government bonds, and implementing other mechanisms to inject more money into the economy.
However, it's crucial to note that adjusting the money supply is just one potential policy response. Policymakers have various tools at their disposal, and the appropriate response depends on the specific economic conditions, objectives, and constraints of the economy in question.