AP® Macroeconomics · Free response

An oil price shock in Velmar: AD-AS, the Phillips curves and the way back

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Long free-response question · four-function calculator · 10 points · about 25 minutes

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The question

Name: ______________________   Date: ____________   An oil price shock in Velmar: AD-AS, the Phillips curves and the way back (10 points)

Velmar, an invented country, is in long-run equilibrium with an unemployment rate of 5 percent, equal to its natural rate, and actual and expected inflation of 2 percent. Then a sudden, large rise in the world price of oil raises production costs for firms across Velmar.

  1. (A) Draw a correctly labeled AD-AS graph showing Velmar's long-run equilibrium, with LRAS, the price level PL1 and full-employment output YF. On your graph, show the short-run effect of the rise in the price of oil, labeling the new price level PL2 and real output Y2. [3 points]

  2. (B) Identify what happens to Velmar's unemployment rate in the short run. [1 point]

  3. (C) Draw a correctly labeled graph of Velmar's short-run and long-run Phillips curves. Label point A where the economy starts, at 5 percent unemployment and 2 percent inflation. On your graph, show the short-run effect of the rise in the price of oil on the curves, and label the economy's new short-run position B. [3 points]

  4. (D) Assume Velmar's government and central bank take no action. Explain how Velmar's economy returns to its long-run equilibrium. In your answer, say what happens to nominal wages and to SRAS. [2 points]

  5. (E) Assume expected inflation in Velmar is still 2 percent. Identify Velmar's unemployment rate and inflation rate at the new long-run equilibrium. [1 point]