ISLMandADAS_Stagflation - M/PSR M/P1 FE2 FE1 r r Poil...

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Unformatted text preview: M/PSR M/P1 FE2 FE1 r r Poil causes price level SRE rSR SRE GE2 GE2 r2 r1 GE1 GE1 P P Md/P (eff1,Y) YSR Y2 Y M/P, Md/P 1 P An increase in the price of oil is an adverse supply shock, which causes a decrease in LRAS2 LRAS1 full employment output, which causes a shift to the left of the FE curve and the LRAS. The increase in the price of oil also increases prices in sectors that depend SRE heavily on oil (many in our economy!), but keep the remaining prices constant. Nevertheless, this causes inflationary pressure, which causes the real money supply PSR oil GE2 to decrease significantly (to the blue line and to SRE in the money market). This P2 P causes GE1 price level causes the LM curve to shift from the black line to the blue line and the short P1 equilibrium point SRE. The SRAS curve shifts upward to the blue line, also to SRE. Output falls to the short run Y and the real interest rate increases. In the long run, however, the price level will fall. This causes real money supply to move from the blue curve to the red curve and the equilibrium to move to GE2. The LM curve also shifts to the red curve and the SRAS shifts to the red curve. Thus in the LR, price level falls, but not to the original price level. Note that because these changes are caused by changes in the price level, that this represents a movement along the AD curve, not a shift of the AD curve. (This was Misty's mistake in the 11:15 class!) LM(PSR) Poil causes price level LM(P1) IS Y P SRAS(PSR) SRAS(P2) SRAS(P1) AD(eff1) YSR Y2 Y1 Y ...
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