Assume that the economy is initially operating at the natura

Assume that the economy is initially operating at the natural level of output. An increase in the price of oil will cause which of the following in the medium run?

Select one:

a. a reduction in output and an increase in the aggregate price level

b. a reduction in the interest rate

c. a reduction in output and a reduction in the interest rate

d. a reduction in unemployment, an increase in the nominal wage, and an increase in the aggregate price level

e. a reduction in the aggregate price level and no change in output

Solution

Correct option is (a).

In the medium run, aggregate supply (AS) curve is upward rising. Increase in price of oil will raise cost of inputs, which will increase production cost, so firms will lower production and output. Aggregate supply will fll, shifting AS curve leftward which whill increase price level and decrease real GDP (known as Stagflation).