Question: Oil prices have risen temporarily, due to political uncertainty in the Middle East. An advisor to the Fed suggests, "Higher oil prices reduce aggregate demand. To offset this we must increase the money supply. Then the price level won't need to adjust to restore equilibrium, and we'll prevent a recession." In this question we will analyze this statement using the FE-IS-LM model.
Consider that an increase in of oil prices reduces the amount of oil used in the production process and results in a negative productivity shock.
a. Explain, with the help of graphs, the direct impact of the oil shock on the FE line.
b. Explain, with the help of graphs, the direct impact of the oil shock on the IS curve.
c. Explain with the help of graphs what happens to the expected real interest rate, output, consumption, savings and investment (If necessary assume that the shift of the FE line is smaller than the shift of the IS curve).
d. Explain with the help of graphs how the economy converges to the general equilibrium after the shock. What happens to the aggregate price level?
e. Explain with the help of graphs what the Fed should do in order to avoid a change in the price level.
f. Use your findings to comment the statement.