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IAI Actuarial Core Principles · Business Economics · Business activity, unemployment and inflation

An economy is initially in equilibrium on the upward-sloping part of its short-run aggregate supply curve. A sharp rise in global crude oil prices raises input costs for Indian manufacturers. Holding aggregate demand constant, what is the most likely short-run effect?

A rise in oil prices is a negative supply shock that shifts short-run aggregate supply to the left. With demand unchanged, the price level rises and real output falls, producing cost-push inflation alongside weaker activity, often called stagflation.

  1. AShort-run aggregate supply shifts left, raising the price level and reducing real outputCorrect
  2. BShort-run aggregate supply shifts right, lowering the price level and raising real output
  3. CAggregate demand shifts left, lowering both the price level and output
  4. DLong-run aggregate supply shifts right, raising potential output
  5. There is a movement up the SRAS curve, raising both prices and output

Explanation

Higher input costs raise the cost of producing at every price level, so SRAS shifts left. With AD unchanged the new equilibrium has a higher price level and lower output, which is stagflation. A movement along SRAS would require a change in AD.

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