Long free-response question

An oil price shock

Units 2, 3, 4 and 5
10 points
About 25 minutes

You can use a calculator on this question, just like on exam day.

A multi-part question that follows one economy through a situation and ties several models together, such as AD–AS, the Phillips curve, the money or reserve market, loanable funds and the foreign exchange market. You draw and label graphs (described in words on this site), name the right policy, do a calculation or two, and explain the chain of effects step by step. On the exam: Question 1 of 3 in Section II (60 minutes for all three, including a 10-minute reading period; 33.35% of the exam score). Worth half the section score; about 25 minutes suggested. A four-function calculator is allowed.

The question

The economy of Pelora is in long-run equilibrium with an unemployment rate of 5 percent, which is its natural rate, and an inflation rate of 2 percent. Then the world price of oil, a key input for Pelora's firms, rises sharply and unexpectedly. Pelora's banking system has limited reserves.

Suggested time: 25 minutes

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Part (a)

2 points

Describe a correctly labeled graph of aggregate demand, short-run aggregate supply, and long-run aggregate supply for Pelora. Show the initial long-run equilibrium, labeling the price level PL1 and the output YF. Then show the short-run effect of the rise in oil prices, labeling the new price level PL2 and real output Y2.

Your answer to part (a)

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Part (b)

1 point

Based on the change in real output shown in part (a), will Pelora's unemployment rate increase, decrease, or remain the same in the short run? Explain.

Your answer to part (b)

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Part (c)

2 points

Describe a correctly labeled graph of the short-run and long-run Phillips curves for Pelora. Plot and label the initial long-run equilibrium as point A, using the numbers given. Then show the short-run effect of the rise in oil prices, labeling the new point B.

Your answer to part (c)

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Part (d)

1 point

Before the oil shock, a bank in Pelora made a one-year loan at a fixed nominal interest rate of 6 percent. Over the year, the actual inflation rate turns out to be 7 percent. Calculate the real interest rate the bank earned on the loan. Show your work.

Your answer to part (d)

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Part (e)

1 point

Based on your answer to part (d), was the bank helped or hurt by the unexpected inflation? Explain.

Your answer to part (e)

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Part (f)

1 point

Assume that policymakers in Pelora take no action. Explain how the economy will return to full employment in the long run.

Your answer to part (f)

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Part (g)

1 point

Suppose instead that Pelora's central bank wants to restore full employment in the short run. Identify the open-market operation it would use.

Your answer to part (g)

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Part (h)

1 point

Based on the open-market operation identified in part (g), will Pelora's price level be higher than, lower than, or the same as PL2 in the short run?

Your answer to part (h)

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