Envision the following scenario, oil prices have fallen 20 percent over the past six months increasing aggregate productivity:

30 points

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a. Using the AS-AD framework, show what happens to the price level and GDP when oil prices fall. Act as if this is a permanent shift in aggregate productivity

b. If the Fed is intent on maintaining a positive inflation rate, what will their policy response need to be to keep inflation at a positive targeted rate?

c. Suppose the oil price shock is actually temporary and that oil prices return to the original price after six months. What would happen to inflation and GDP as the economy adjusts? What

would (or should if you believe in active policy) be the Federal Reserve's response to the adjustment?