Figure 9-7

Short and Medium Run IS

Effects of an Increase in

Real interest rate, r

the Price of Oil
MyEconLab Animation rn
A
LM

rn LM
AA

Yn Yn
Output, Y

PC

PC
A
Change in inflation rate

p – p(–1)

A A
0
Yn Yn

Output, Y

inflation. For given wages, the price of oil leads firms to increase their prices, so inflation
is higher. The short-run equilibrium is given by point A= in the top and bottom panels. In
the short run, output does not change, but inflation is higher.
Turn to the dynamics. If the central bank were to leave the policy rate unchanged,
output would continue to exceed the now lower level of potential output, and infla-
tion would keep increasing. Thus, at some point, the central bank will increase the
policy rate to stabilize inflation. As it does so, the economy moves up from A= to A==
along the IS curve in the top panel, and down from A= to A== along the PC curve in the
bottom panel. As output decreases to its lower level, inflation continues to increase,
although more and more slowly until eventually it becomes stable again. Once the
economy is at point A==, the economy is in its medium-run equilibrium. Because po-
This is especially true if the oil tential output is lower, the increase in the price of oil is reflected in a permanently
producers are located in other lower level of output. Note that along the way, lower output is associated with higher
countries than the oil buyers inflation, a combination that economists call stagflation (stag for stagnation, and
(which is the case when the
United States buys oil from the
flation for inflation).
Middle East for example). As As in the previous sections, this description raises a number of issues. The first
the price increases and their in- is our assumption that the IS curve does not shift. In fact, there are many channels
come increases, the oil produc- through which the increase in the price of oil may affect demand and shift the IS curve.
ers are likely to spend most of it The higher price of oil may lead firms to change their investment plans, canceling some
on their own goods, not on the
goods produced by the oil buy-
investment projects, shifting to less energy-intensive equipment. The increase in the
ers. Thus, demand for domes- price of oil also redistributes income from oil buyers to oil producers. Oil producers may
tic goods is likely to go down. c spend less than oil buyers, leading to a decrease in demand. So it may well be that the IS

210 The Medium Run The Core