Question 4:

Use the Aggregate Demand and Aggregate Supply model to analyze the US economy below. In 1979 a cartel of oil producers (OPEP) increased oil prices dramatically:

(a) Draw the aggregate supply curves in the short and long run and the aggregate demand. Assume that the economy was in equilibrium before this oil shock. Show the effect of this negative supply shock, and show the path the economy will take in the short run. Be sure to show: i. the direction the curve shifts, ii. the short-run equilibrium values.

(b) State in words what happens to prices and output in the short run. In addition, in the early 1980s, the government was pursuing expansionary policy (increase in government expenses on defense and cut in taxes - Reagan era).

(c) Redraw the aggregate supply curves in the short and long run and the aggregate demand from question (a) with the negative supply shock and now with this positive demand shock. Show the effect of this positive demand shock, and show the path the economy will take in the short run from the final short run equilibrium point you found in (a) to a new one due to this new shock. Be sure to show: i. the direction the curve shifts, ii. the short-run equilibrium values.

(d) State in words what happens to prices and output in the short run.

(e) Given this expansionary policy and the effect on inflation, the Fed decided to intervene in the economy in the 1980s to keep prices stable. What policy the Fed may have pursued to accomplish that? Redraw the diagram from (c) with the supply and demand shock studied in items (a) and (c), and show the effect of this new demand shock. Show the path the economy will take under the Fed intervention. Be sure to show: i. the direction the curve shifts, ii. the new short-run equilibrium values.

(f) What is the impact of the Fed's policy on prices, income and output in the short run? Would you recommend this policy?

(g) What do you think it happened in the long run? Use the AD-AS curve to help answering your question