Answer to Question #233840 in Macroeconomics for jac

Question

Assume that the economy starts at the natural level of output. Now suppose there is a permanent increase in the relative price of oil.

a. Using the wage-setting and price-setting diagram (and explaining the intuition of the curves), show what happens to the unemployment rate in the medium run. Why does this happen? (4 marks)

b. Assuming a simple production function, Y=N, where Y is output and N is employment, explain what happens to mediumrun equilibrium output. (2 marks)

c. Assume the central bank has an inflation target. In an AS−AD diagram (explaining what lies behind the curves), show what happens to output and inflation in the short run and the medium run. (4 marks)

Answer 1

Economics as a subject deals with the the allocation of scarce resources among humans with unlimited wants. For production, raw materials are used as inputs and more complicated a government body was formed. Proper rules and regulations and law and order are imposed which makes economic agents invest in land, buy machinery and undergo production processes to make money. The government keeps economic stability in place along with intervening in the private market so that the economic pie gets distributed as fairly as possible.

a) The wage-setting curve and the price-setting curve determines the level of employment and unemployment that exists in the economy and the amount that a labourer receives for his work. The price-setting curve is a horizontal straight line that represents the marginal revenue received for each unit of goods produced. The wage-setting curve is an upward sloping curve that describes the positive relation of labour with wage, I.e high wage increases labour supply. Together, the two curves give the wage rate existing in the economy.

When there is an increase in oil price, the cost of production goes up. It costs to produce the same amount of goods and resources. The marginal cost increases which mean there is an increase in the price of the goods as well. Hence, in the medium run, the price rise leads to an increase in the real wage.

As seen in the diagram, the real wage rate increases and the level of unemployment in the economy decreases.

b. As a result of an increase in the price of oil, the cost of production increases leading to An increase in the real wage rate. As the rate of employment increases, more people are able to afford goods for consumption. This leads to a rise in aggregate demand as well. Thus, the output of the economy increases.

c. With an increase in the price of oil, since the cost of production increases, there is a reduction in their profit. Hence, they have to reduce their output or production so that they can keep their profit margin. Hence, the aggregate supply curve shifts to the left and there is an increase in price and decrease in output.