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 in response to the oil price increase, we need to analyze the impact of changing the money supply on aggregate demand (AD).
First, let's understand the relationship between the money supply and AD. An increase in the money supply stimulates spending and consumption, which leads to an increase in aggregate demand. Conversely, a decrease in the money supply reduces spending and consumption, leading to a decrease in aggregate demand.
When there is a temporary but significant increase in oil prices, it affects costs for businesses and consumers. This increase in input costs for businesses reduces their profitability, leading to a decrease in the overall supply of goods and services. As a result, the SRAS curve shifts to the left.
Now, if policymakers increase the quantity of money in circulation to counteract the adverse effects of the oil price increase, it will lead to an increase in aggregate demand. However, the SRAS curve is already shifting leftward due to higher oil prices, reducing the supply of goods and services. The increase in aggregate demand will exacerbate inflationary pressures by pushing prices even higher.
To prevent the equilibrium price level from changing, policymakers should decrease the quantity of money in circulation. By reducing the money supply, they would reduce aggregate demand. This decrease in aggregate demand would counterbalance the leftward shift of the SRAS curve caused by the higher oil prices, helping to keep the equilibrium price level relatively stable.
To summarize, policymakers should decrease the quantity of money in circulation if they wish to prevent the equilibrium price level from changing in response to a temporary but significant increase in oil prices. This would help offset the inflationary pressures caused by the oil price increase and stabilize the overall price level.
To prevent the equilibrium price level from changing in response to the temporary increase in oil prices, policymakers should increase the quantity of money in circulation.
When oil prices increase, the cost of production for businesses rises, causing a leftward shift of the SRAS curve. As a result, the aggregate price level increases, leading to higher inflation. By increasing the quantity of money in circulation, policymakers can counteract the leftward shift of the SRAS curve and stabilize the aggregate price level.
Increasing the quantity of money in circulation will shift the aggregate demand (AD) curve to the right. This will lead to higher levels of consumer spending, investment, and net exports, thereby expanding the overall economic activity. Consequently, the increase in aggregate demand will offset the effect of the leftward shift of the SRAS curve caused by higher oil prices, returning the economy to the initial equilibrium price level.
By adjusting the quantity of money in circulation, policymakers can manage the balance between Aggregate Demand and Short-Run Aggregate Supply, stabilizing the general price level in the economy.