Macroeconomics For Business Managers Econ 52 651 Assignment

Macroeconomics For Business Managers Econ 52 651assignment 5 Chapte

Use the IS-LM-PC model to illustrate how the economy adjusts to an increase in taxes both in the short run and in the medium run. What happens to the natural rate of unemployment and the inflation rate when the real price of oil increases? (Hint: Use WS-PS and also IS-LM-PC models).

Paper For Above instruction

The interplay between fiscal policy, commodity prices, and macroeconomic variables such as unemployment and inflation is central to understanding economic stability and growth. Specifically, the effect of an increase in taxes and rising oil prices can be analyzed through the IS-LM-PC model, which incorporates goods market equilibrium (IS curve), money market equilibrium (LM curve), and Phillips curve considerations for inflation and unemployment.

In the short run, an increase in taxes leads to a reduction in disposable income, decreasing consumption and aggregate demand. This shift results in a leftward movement of the IS curve, indicating a lower level of output at any given interest rate. As the IS curve shifts, the intersection point with the LM curve moves to a lower income and interest rate, signaling an economic slowdown and potential increase in unemployment in the short term.

Simultaneously, the decrease in demand and output places downward pressure on the economy’s inflation rate. The Phillips curve, which depicts the inverse relationship between unemployment and inflation, suggests that as unemployment rises, inflation tends to decrease, reflecting less upward pressure on prices given the slack in the labor market. The short-run adjustment thus results in higher unemployment and lower inflation, consistent with the Phillips curve dynamics.

In the medium run, however, the economy adjusts through price and wage flexibility. The reduction in inflationary pressures influences expectations, causing the short-run Phillips curve to shift. Over time, anchoring inflation expectations leads the economy toward its natural rate of unemployment, where the unemployment rate stabilizes at its natural level. This natural rate, influenced by structural factors and monetary policy, remains unaffected by short-term fiscal measures like tax increases, assuming no fundamental structural change occurs.

When considering an increase in the real price of oil, the effects on the economy are multifaceted. Oil is a key input in production and transportation; an increase in its price raises production costs, causing supply shocks. In the WS-PS framework (Wage-Setting and Price-Setting relations), higher oil prices negatively impact the real wage and increase production costs, leading to upward shifts in the Phillips curve. This results in stagflation—a combination of stagnant growth, higher unemployment, and rising inflation—as the Phillips curve shifts upward.

The IS curve might also shift inward due to reduced consumption and investment, stemming from increased costs and inflation expectations. The LM curve's movement depends on monetary policy response—if the central bank accommodates inflation by increasing the money supply, the LM curve might shift to restore equilibrium, but if it constrains money supply, the reduction in output and increases in unemployment persist.

Regarding the natural rate of unemployment, an oil supply shock can induce a persistent increase if it leads to structural changes in the economy—e.g., reduced productive capacity or labor market mismatches—making the natural rate higher. The inflation rate tends to accelerate because higher oil prices feed into core prices and inflation expectations, which, if unanchored, can lead to a wage-price spiral.

In sum, the IS-LM-PC model illustrates that short-term impacts of fiscal policy or commodity price shocks involve movements along the Phillips curve, affecting unemployment and inflation. Over the medium term, inflation expectations and supply-side adjustments determine the economy's return to the natural rate of unemployment, but persistent supply shocks like oil price increases can cause a lasting increase in inflation and the natural rate, complicating stabilization policies.

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