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Supply shocks and price stabilization

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Both the long-run aggregate supply curve and the short-run aggregate supply curve shift in response to changes in the availability of labor or capital or to changes in technology and productivity. A widespread temporary change in the prices of factors of production, however, can cause a shift in the short-run aggregate supply curve without affecting the long-run aggregate supply curve.

Suppose there is a temporary but significant increase in oil prices in an economy with an upward-sloping Short-Run Aggregate Supply (SRAS) curve. If policymakers wish to prevent the equilibrium price level from changing in response to the oil price increase, should they increase or decrease the quantity of money in circulation? Why?

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The situation described above, where there is a sudden increase in the cost of an input, is called a supply shock. You are correct, the appropriate response is to reduce the money supply, and MV=PY does show how that a falling M could result in a falling P (lower price level). However, because of the V in this equation, the effect of M on P and Y is not a given. Also, it is called the demand function for money equation, not the equation for aggregate demand. That equation is Y = C(Y - T) + I(r) + G + NX. It has to do with consumption, government spending and so forth.

To see how money supply affects ...

Solution Summary

This solution discusses how policymakers can respond to an increase in oil prices to prevent and increase in prices.