Question 1. (12 points each)

In 1973, because of a disruption in crude oil supplies, the price of oil increased sharply. As a consequence, many countries entered a recession. Output fell and the price level/inflation rate increased. This recession is called the 1973 oil crisis. In this question, we explain this event using both the IS-LM and the AD-AS model.

(1) Suppose the economy is in the long-run equilibrium. We interpret the increase in oil price as the decrease in productivity. Using the IS-LM diagram, explain what will happen to the economy in the long run when the oil price increases. What will happen to output, the real interest rate, and the price level? You need to plot how the FE/IS/LM curves shift in the IS-LM diagram. What will happen to consumption and investment?

(2) Instead, we use the AD-AS diagram. Using the AD-AS diagram, explain what will happen to the economy in the long run when the oil price increases.

(3) Suppose the central bank tries to stabilize output fluctuations. What would the central bank have to do with money supply to offset the effect of the oil price increase on output? Explain how the action taken by the central bank affects the economy using the IS-LM diagram. Hint: Focus on the effect of money supply in the short run.