In the accompanying diagram, the economy is in long-run macroeconomic equilibrium at point E₁when an oil shock shifts the short-run aggregate supply curve to SRAS₂. Based on the diagram, answer the following questions.

a. How do the aggregate price level and aggregate output change in the short run as a result of the oil shock? What is this phenomenon known as?

b. What fiscal or monetary policies can the government use to address the effects of the supply shock? Use a diagram that shows the effect of policies chosen to address the change in real GDP. Use another diagram to show the effect of policies chosen to address the change in the aggregate price level.

c. Why do supply shocks present a dilemma for government policy makers?

Transcribed Image Text:

LRAS Aggregate price level SRAS2 SRAS1 E1 P1 AD1 Y4 Real GDP