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Imagine that a new oil eld is discovered in the East Sea, which might lead to a fall in oil prices if the oil eld is developed. We will consider two scenarios of how the news of a new oil eld aects the economy; [Scenario 1] The oil price drop is going to boost supply that is, for the same amount of inputs, we will get more output since fewer resources will have to be used to pay for oil; [Scenario 2] In the short run, the news could create deationary pressures that is, since the cost of one key input, energy, becomes lower, rms will charge lower prices overall.

[Scenario 1] Consider a CLASSICAL model (with both investment and consumption on the demand side). Suppose that people interpret that the news is a positive TEMPORARY shock on productivity, A. That is, the size of oil eld is so small that At will increase but At+1 and all future productivity are unaected. (a) What would happen to output (Y ), interest rate (r), and prices (P)? Use graph(s) and explain. Can this explain Goldilocks economy? (Note: A Goldilocks economy refers to the ideal state of an economy, with moderate economic growth and low ination.) (b) Suppose that the BOK (a central bank) dislikes price instability, so it wants to change money supply in order to leave the price level unchanged. How does the money supply (Ms ) need to change so as to achieve price stability? Use graphs and explain. (c) If people interpret that the news is a positive PERMANENT shock on productivity, A, (that is, the size of oil eld is huge, so At, At+1, and all future productivity increase), what would happen to output (Y ), interest rates (r) and prices (P)? Can this still explain Goldilocks economy?

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