Question

Discuss the effects of a shock that increases oil prices in the AD-AS model. Be sure to explain also the problem of stagflation.

Answer 1

Higher oil prices will lead to an improvement in the current account position of oil exporters like OPEC countries.

A marked rise in oil prices will contribute to a higher inflation level. This is because transport costs will rise leading to higher prices for many goods. This will be cost-push inflation which is quite different to inflation caused by rising aggregate demand/excess growth. Basically due to rise in prices aggregate supply ( AS ) get affected in short run , AS shift towards leftwards due to rise in price in AD AS model . So due to leftward shift of AS curve , output of the economy falls and price rises .

Consumers will see a fall in discretionary income. They face higher transport costs, but don’t have the compensation of rising incomes. Higher oil prices can lead to slower economic growth – particularly a problem if consumer spending is weak.

Cost-push staginflation caused by rising oil prices presents a dilemma to policymakers. Higher inflation usually requires higher interest rates to keep inflation on target. But, to reduce inflation may not be appropriate because output could be well below full employment.