To plot the AD/AS diagram, we need to understand the components of the diagram: AS represents aggregate supply, and AD represents aggregate demand. In period 0, equilibrium is at the intersection of AD0 and AS0, with a nominal interest rate of 3%. b. If oil prices fall in period 1, the AS curve shifts to the right. The nominal interest rate stays the same, but inflation decreases, short-run output increases, and the real interest rate decreases.
a. To plot the AD/AS diagram, we need to first understand the components of the diagram. The AS curve represents the aggregate supply, which shows the quantity of goods and services that firms are willing to produce at different price levels. The AD curve represents the aggregate demand, which shows the quantity of goods and services that consumers, businesses, and the government are willing to purchase at different price levels.
In period 0, when the economy is in long-run equilibrium, AD0 intersects AS0 at a point that represents the price level (P0) and the output level (Y0). The nominal interest rate is the combination of the long-run real interest rate (1%) and the expected inflation rate (2%), resulting in a nominal interest rate of 3%.
b. The shock to oil prices in period 1 would cause a shift in the AS curve. If oil prices fall, the cost of production decreases, leading to a rightward shift of the AS curve (AS1). The AD curve (AD1) is unaffected. Assuming adaptive expectations, the nominal interest rate would stay the same between period 0 and period 1, as it is determined by the long-run real interest rate and the expected inflation rate. Inflation would decrease due to the fall in oil prices, short-run output would increase, and the real interest rate would decrease.