Question

Analyze the effects of a permanent increase in the price of oil (a permanent adverse supply shock) on current output, employment, the real wage, na- tional saving, investment, and the real interest rate. Show that in this case, unlike the case of a tempo- rary supply shock, the real interest rate need not change. (Hint: A permanent adverse supply shock lowers the current productivity of capital and la- bor, just as a temporary supply shock does. In ad- dition, a permanent supply shock lowers both the expected future MPK and households' expected future incomes.)

Answer 1

A permanent increase in oil prices has several effects on the economy, including a decrease in output and employment, a lower real wage, reduced national saving and investment, and the real interest rate may not change.

Step-by-step explanation:

An increase in the price of oil, a permanent adverse supply shock, has several effects on the economy:

1. Current output and employment decrease because the higher oil prices increase production costs and reduce firms' profitability, leading to lower output and job cuts.
2. The real wage decreases as firms cut costs by reducing wages or laying off workers.
3. National saving decreases because higher oil prices reduce household income, leading to lower saving.
4. Investment decreases as firms have less profit and reduced expectations for future profitability.
5. The real interest rate may not change because, in the long run, the supply of loanable funds is determined by national saving, which decreases due to lower income.