Question

In: Economics

show how a major decrease in the price of oil would affect an economy using an...

show how a major decrease in the price of oil would affect an economy using an as-ad model

Solutions

Expert Solution

To understand the answer you first need to have basic knowledge of AD and AS and how they move. Essentially, talking about AS the two most important factors that affect it are prices of inputs (various raw materials used for production, in this case, oil is a very significant input for production in any given economy) and the second factor is productivity growth (productivity is output per unit labour/machinery etc). Increases in productivity shift AS rightwards and decrease shifts it leftwards. Similarly when the price of inputs fall, profit margin increases and AS shifts rightwards and when price decreases then AS shifts leftwards.

Now as per the question when the price of oil majorly decreases (aforesaid oil is a significant input) then the AS curve will shift rightwards, employment will rise and inflation will dip down.

As the AS curve shifts rightward the price level of the economy falls from P0 to P1 and the Real output will increase from Q0 to Q1. This means the economy will have the potential to grow in size because of increase in AS.

Further, as oil (input) becomes cheaper, the prices of things like airline tickets, fuel prices, electricity costs will also fall and thereby can lead to an increase in aggregate demand. An increase in aggregate demand will lead to a rightward shift of AD curve. This rightward shift in AD will further lead to an increase in output from Q1 to Q2 and the real output of the economy will further increase.

The total result of the rightward shift of both AD and AS will lead to an increase in output.

In real life, we can understand the impact of decrease in oil price by taking India's example. India is majorly an oil importing country so as the price falls the money spent on imports will decrease, current account defeict can be reduced and economy can prosper. This can be substantiated using the AD-AS model explained above.


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