IS-MP-AD-IA model. In 2020, oil prices have fallen dramatically, from about $60/barrel to $12/barrel, a huge decline. For simplicity, let's assume that the economy was starting from steady state, so that output was equal to potential output just before the shock, and let's assume that the oil price shock is the only shock hitting the economy, to focus attention on the effects of that shock in particular.

a) In the AD-IA diagram, which curve is initially shifted by the fall in oil prices? Explain which way the curve shifts, and why. Draw a diagram to help explain your answer. What is the short-run effect of the oil price shock on output and inflation?

b) In the IS-MP diagram, what is the short-run effect of the oil price shock on the IS and MP curves? Draw a diagram to help explain your answer. What happens to the real interest rate in the short run?

c) What is the short-run effect of the shock on consumption, investment, and government purchases? Briefly explain why.

d) According to the IS-MP-AD-IA model, what happens to output and inflation over time in response to the shock? Draw a diagram to help explain your answer.

e) What happens to the AD-IA and IS-MP diagrams in the long run? Draw those diagrams to explain your answer. If oil prices remain at $12/barrel for the indefinite future, what would be the long-run effect of that decline on output, inflation, and the real interest rate?

f) What would be the long-run effect of the oil price shock on consumption, investment, and government purchases? Briefly explain why.