Q 3&4

3. Consider the standard aggregate supply and demand model that is in long run equilibrium. a. There is a sudden and drastic increase in the price of oil. Use a graph with the AD/AS framework to illustrate the effect on the price level and real output. b. Does unemployment increase or decrease as a result of this shock? Does inflation increase or decrease? c. The government does not want to wait for the economy to self adjust. One politician argues that the priority is to correct the price level. How could the Assignment 4 - EC0211 government do this with fiscal policy? On a separate graph, draw how it could be done. d. A different politician argues that returning to potential output should be the priority. How could the government achieve this with fiscal policy? On a separate graph, show how it could be done. e. If the government does nothing, how would the economy self-adjust in the long-run? On a separate graph, draw how this works. f. Compare the options of (c) and (d). What tradeoff befalling policymakers facing supply shocks is demonstrated by the model? g. If you were a policymaker, which corrective measure would you employ? Would you rather fix the inflation or unemployment? Why? 4. Consider the standard aggregate supply and demand model that is in long run equilibrium. a. There is a sudden recession in a trade partner's economy which reduces foreign income. Use a graph with the AD/AS framework to illustrate the effect on the price level and real output. b. Does this create a recessionary or inflationary gap in the home economy? c. Due to automatic stabilizers, what will naturally happen to the budget deficit as a result of the shock described in (a)? Why? d. If the government is required to run a balanced budget (G-T), what adjustments would need to happen in order to counteract the effect on the budget deficit from the shock in (a)? e. Draw the effect of the policy from (d) on the AD/AS graph. Is the result desirable? f. If the government were not required to run a balanced budget, what type of fiscal policy should they undertake to counteract the undesirable effect from the shock in (a)? Draw this on the graph. g. After the shock from (a), how would the economy self-adjust in the long run? Draw this on a new graph. h. What is the short-run result if the government is late to react to the shock from (a) and undertakes the policy from (f) even though the economy has already self-adjusted? i. What does your answer to (h) indicate about the importance of fiscal timing?