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Explain and illustrate the short-run effect of a temporary oil price shock on macroeconomic equilibrium using the AD-AS model

In our analysis of Ch.10, we studied the aggregate demand (AD) and aggregate supply (AS) model in the context of recessions, expansions and supply shocks on economic activity. In addition, in Ch.12, we discussed the role of monetary policy on economic activity. As a result, the different type of ‘shocks’ that affect economic activity bare consequences on the level of inflation and output. Central banks, such as the RBA, can simultaneously pursue “stabilising prices” (i.e., maintaining a targeted level of inflation) and “stabilising economic activity” (i.e., economic activity remaining at its potential level). However, not all shocks to the economy are equal. In response to this, economists/policymakers can either achieve price stability or economic stability, but not both. This trade-off ultimately poses a dilemma for central banks with dual mandates such as price stability and economic activity. On the other hand, New-Keynesian theory suggests that there is no trade-off between price stability and maintaining economic activity – something called the “divine coincidence”. Recall the long-run potential macroeconomic equilibrium condition where the economy is at long-run macroeconomic equilibrium (point 1); output (or real GDP) is at its potential level at ???? ???? ; and inflation (or the price level) is at its target rate (set by the central bank) at ???? �

Question 1 [3 marks total]. While evidence shows that the Global Financial Crisis (GFC) impacted firms (small to large), it is generally accepted (and shown by empirical studies) that the GFC predominantly impacted on households/consumer spending (i.e., on aggregate demand). Assume this is the case. Also assume that there is no fiscal policy response from the government.

a. Explain and illustrate the short-run effect of the GFC on macroeconomic equilibrium using the AD-AS model. [0.5 marks]

b. Explain and illustrate the adjustment process to back to long-run equilibrium based on the following

i. Self-correcting mechanism (i.e., with no policy response). [1 mark]

ii. Active stabilisation response (i.e., with policy response). [1.5 marks]

Question 2 [3 marks total]. The last several decades has seen a significant amount of human capital entering Australia from foreign nations ranging from low-skilled to high skilled labour and seen as an important factor of the rate of invention and innovation within an economy. Imposing restrictions on skilled immigration policy may deteriorate the overall level of human capital given it is an integral part of production, and hence output. COVID19 has also shown the restrictive effects of the movement of human capital across countries. Assume there is no fiscal policy response from the government for the following questions.

a. Explain and illustrate the short-run effect of the Australian Government imposing a strict ban on human capital entering Australia, by significantly reducing the number of skilled immigrants entering the nation over the next 20 years on macroeconomic equilibrium using the AD-AS model. [0.5 marks]

b. Explain and illustrate the adjustment process to back to long-run equilibrium based on the following:

i. Self-correcting mechanism (i.e., with no policy response). [1 mark]

ii. Active stabilisation response (i.e., with policy response). [1.5 marks]

Question 3 [3 marks total]. Oil price shocks have been a reoccurring phenomenon over the last fifty years, causing significant fluctuations in the price of oil. Examples of oil price  Page 4 of 4 shocks include the early 1970s caused by the OPEC oil embargo, the early 1990s caused by the Gulf War, and the Arab Spring during the early 2010s. Oil-importing nations like Australia are significantly affected by rising oil prices. Nonetheless, evidence has shown that oil price shocks are a temporary phenomenon and eventually, prices decline. Assume that there is no fiscal policy response from the government in relation to an oil price shock.

a. Explain and illustrate the short-run effect of a temporary oil price shock on macroeconomic equilibrium using the AD-AS model. [0.5 marks]

b. Explain and illustrate the adjustment process to back to long-run equilibrium based on the following:

i. Self-correcting mechanism (i.e., with no policy response). [1 mark]

ii. Active stabilisation response (i.e., with policy response). [Hint: there could be two active stabilisation polices here]. [1.5 marks]

Question 4 Based on your answers in part (b) for Q1, Q2, and Q3, does the ‘divine coincidence’ hold? [1 mark]

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