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      Question

      The expectations-augmented Phillips curve is: u = u* βˆ’

      Ξ±(Ο€ βˆ’ πᡉ). An adverse oil price supply shock occurs. Which correctly describes short-run and long-run consequences?
      A Short run: both u and Ο€ rise (stagflation), curve shifts right; long run: economy returns to u* at the original inflation rate as oil prices normalise (temporary shock case) Correct Answer Incorrect Answer
      B Short run: u falls and Ο€ rises, moving along the existing curve; long run: curve shifts left as expectations adjust Correct Answer Incorrect Answer
      C Short run: stagflation β€” u* rises, curve shifts right; long run: if shock is permanent, the long-run vertical Phillips curve also shifts right to a higher u*, and the economy settles at the new higher u* with any chosen inflation rate Correct Answer Incorrect Answer
      D Supply shocks do not affect the Phillips curve β€” they only shift the IS curve in the AD-AS framework Correct Answer Incorrect Answer

      Solution

      A permanent adverse supply shock raises structural unemployment (u* rises) β€” higher oil prices permanently raise production costs, lowering equilibrium employment. Both the short-run and long-run Phillips curves shift right. If the shock is temporary (option A): economy eventually returns to original u*. Option (C) is the general answer covering the permanent case. Option (D) is wrong: supply shocks directly shift the Phillips curve (stagflation = simultaneous rise in u and Ο€). Option (B) is wrong: a supply shock shifts the curve, does not move along it.

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