5. Supposethe economy is initially in the long-run equilibrium in the real output market.

Draw the initial LR equilibrium. Label the diagram completely.

Now suppose that due to increase in oil prices, cost of production has increased. Show on an Aggregate Demand and Aggregate Supply diagram that you draw in part a) and explain what happens to the economy in the short run? What do we call this situation?

Explain what policymakers can do to bring the output back to its initial long run level? What can they do to keep prices at the initial long run level? What is the trade-off they face in each case? You can use the same diagram to show the policy impact or you can draw a new one.