1) Suppoer the economy is operating at full employment and foreign countries raise the world price of oil. Assuming policy-makers do not take any actions,describe what will happen to price and output in the short run and long run.


2) Suppose the Federal Reserve decided it wanted to offset any adverse effects on output. What actions could it take? What would be the consequences for the price level if the Fed used monetary policy to fight unemployment?

3) Economists claim that supply shocks create a dilemma for the Federal Reserve that shocks to demand (for example, from investment) do not create. Explain this point using your answer to (2) and the aggregate demand-and-supply diagram.

4) Economists who believe that the transition from the short run to the long run occurs rapidly do not generally favor active use of stabilization policy. Use the aggregate demand and supply graphs to illustrate how active policy, with a rapid adjustment process, could destablize the economy.

each question needs a diagram to illustrate how it works, can anyone help me to answer the questions please?

1) Start by drawing aggregate supply and demand curves. Oil is generally an input to production. An increase in price should shift the supply curve inward. What happens to price? quantity=GNP? In the long run, supply and demand are more elastic. Redo with more elastic curves.

2) What are the tools the Fed has to control the money supply. For your graph, use IS and LM curves. (The Fed shifts the LM curve). Also use the "quantity theory of money" MV=PQ.

3) The point in 3 is true if "shocks" are always bad (ie. a disruption of supply or demand) Rarely do we worry about "positive" shocks. Since the Fed is in charge of keeping inflation and low, negative supply shocks raise prices, negative demand shock lower prices.

4) What are forms of stabilization policy. And how effective would they be if the economy recovered from shocks very quickly? Would they cause alternative problems? Hint: yes.

Take it from here. Repost if you have specific questions.

Sure! I'd be happy to help you answer these questions and provide diagrams to illustrate them. Let's go through each question one by one.

1) If the economy is operating at full employment and foreign countries raise the world price of oil, there will be a negative supply shock. This means that the cost of production will increase for firms due to higher oil prices. In the short run, firms will face higher input costs, leading to a decrease in aggregate supply (AS) and a shift to the left of the AS curve. This will cause both prices and output to decrease. Here's a diagram to illustrate this:

[AS DIAGRAM]
The initial equilibrium with full employment is shown as E1 in the diagram. The decrease in aggregate supply leads to a new equilibrium, E2, with a lower level of output and higher prices.

In the long run, however, the economy will adjust to the higher oil prices. Over time, wages and other input costs will adjust, and firms will find ways to increase efficiency and productivity. This will lead to an increase in aggregate supply, shifting the AS curve back to the right. Eventually, the economy will reach a new equilibrium at full employment, but at a higher price level. Here's a diagram to illustrate this:

[AS DIAGRAM]
In the long run, the increase in aggregate supply shifts the AS curve to the right, and the economy returns to full employment at a higher price level.

2) If the Federal Reserve wants to offset any adverse effects on output caused by the oil price shock, it can use expansionary monetary policy. This typically involves decreasing interest rates and implementing measures to increase the money supply. By lowering interest rates, the Fed aims to stimulate borrowing, investment, and consumer spending, which can help boost aggregate demand (AD) and output. Here's a diagram to illustrate this:

[AD DIAGRAM]
Expansionary monetary policy shifts the AD curve to the right, leading to an increase in both output and the price level.

However, there can be consequences for the price level when the Fed uses monetary policy to fight unemployment. If the Fed increases the money supply too much or for too long, it can lead to an increase in inflation. This is because an excess supply of money in the economy can increase demand without a corresponding increase in output, causing prices to rise. It is a balancing act for the Fed to use monetary policy to stimulate the economy without causing excessive inflation.

3) Supply shocks create a dilemma for the Federal Reserve that demand shocks do not create because they impact both inflation and output. In the case of an oil price shock, which is a negative supply shock, it leads to higher prices and reduced output. If the Fed uses expansionary monetary policy to offset the impact on output, it can inadvertently lead to higher inflation.

[AD-AS DIAGRAM]
In this diagram, the initial equilibrium E1 represents the shock to AS due to higher oil prices, leading to a decrease in output and an increase in the price level. If the Fed uses expansionary monetary policy to shift the AD curve to the right, it can initially increase output but also cause further inflation, as shown by the shift from AD1 to AD2. This creates a trade-off for the Fed, as it must consider both the impact on output and inflation when using monetary policy.

4) Economists who believe that the transition from the short run to the long run occurs rapidly are often skeptical of active use of stabilization policy. This is because active policy with a rapid adjustment process can potentially destabilize the economy rather than stabilize it.

[AD-AS DIAGRAM]
In this diagram, the initial equilibrium E1 represents the short-run equilibrium. If policymakers implement active expansionary fiscal or monetary policy to increase aggregate demand (AD), it can shift the AD curve to the right, as shown by the shift from AD1 to AD2. This can temporarily increase output and decrease unemployment in the short run.

However, if the economy is already operating close to full employment in the short run, an increase in aggregate demand may lead to inflationary pressures. In the long run, as wages and prices adjust, the aggregate supply curve (AS) will shift to the left to restore equilibrium, as shown by the shift from AS1 to AS2. This will result in a higher price level but no sustained increase in output or employment.

Therefore, economists who favor a rapid adjustment process argue that active stabilization policy can potentially cause destabilization, as the economy returns to its long-run equilibrium without any sustained improvements in output or employment.

I hope these explanations and diagrams help you understand the concepts better! Let me know if you have any further questions.