Question

Using the Case Study below, answer the following questions

Case Study

Some of the largest economic fluctuations in the U.S. economy since 1970 have originated in the oil fields of the Middle East. Crude oil is a key input into the production of many goods and services, and much of the world’s oil comes from Saudi Arabia, Kuwait and other Middle Eastern countries. When some event (usually political in origin) reduces the supply of crude oil flowing from this region, the price of oil rises around the world. U.S. firms that produce gasoline, tires, and many other products experience rising costs, and they find it less profitable to supply their output of goods and services at any given price level. The first episode of this sort occurred in the mid-1970s. The countries with large oil reserves got together as members of OPEC (the Organization of Petroleum Exporting Countries). OPEC reduced production and oil approximately doubled in price from 1973 to 1975.

Almost the same thing happened a few years later. In the late 1970s, the OPEC countries again restricted the supply of oil to raise the price. From 1978 to 1981, the price of oil more than doubled. In 1986, squabbling broke out among members of OPEC. Member countries reneged on their agreements to restrict oil production. In the world market for crude oil, prices fell by a half. This fall in oil prices reduced costs to U.S. firms. In recent years, the world market for oil has not been as important a source of economic fluctuations. Part of the reason is that conservation efforts and changes in technology have reduced the economy’s dependence on oil.

a. Explain the short-run and long-run impacts of oil price increase on output and price level in the U.S. during 1973-1975 periods using the model of aggregate demand and aggregate supply. No need to draw the AD-AS diagram. Explain in words.

Note (required in the answer) : 1) what would happen to the AS-AD diagram in the SHORT RUN (FIRST PARAGRAPH)

2) link it back with the impacts of oil price increase on output and price level in the U.S. during 1973-1975 (FIRST PARAGRAPH)   

3) what would happen to the AS-AD diagram in the long run (SECOND PARAGRAPH)

4) link it back with the impacts of oil price increase on output and price level in the U.S. during 1973-1975 (SECOND PARAGRAPH)

b. Explain the short-run and long-run impacts of oil price fall on output and price level in the U.S. in 1986, using the model of aggregate demand and aggregate supply. No need to draw the AD-AS diagram. Explain in words.

Note (required in the answer) : 1) what would happen to the AS-AD diagram in the SHORT RUN (FIRST PARAGRAPH)

2) link it back with the impacts of oil price fall on output and price level in the U.S. in 1986 (FIRST PARAGRAPH)   

3) what would happen to the AS-AD diagram in the long run (SECOND PARAGRAPH)

4) link it back with the impacts of oil price fall on output and price level in the U.S. in 1986 (SECOND PARAGRAPH)  

Refer to case study

Subject (Macroeconomics)

Answer 1

a). An increase in the oil prices initially leads to a shift in the supply curve of oil to shift to the left, thereby leading to a rise in the equilibrium price level. However, over the long time when there is an improvement in technology for oil extraction, this supply curve starts to shift down to the right, thereby causing the equilibrium price level to fall down. This is what was observed in the US during the mid-1970s. A reduction in the supply of oil led to doubling of oil prices, thereby leading to the reduced output of products that required oil as an input, thereby causing the prices of those products to rise. A very similar incidence happened in the late 1970s, when the price of oil doubled thus causing the prices of oil-dependent products to rise again.

b). The fall in the price of oil leads to a rightward shift in the supply curve of oil-dependent products, indicating an increase in the supply of those products. These decrease in prices causes an increase in demand for those products thereby leading to a rightward shift of the demand curve. Ultimately, the new equilibrium price returns back to the old equilibrium price level, however the total production of oil increases. This is what happened in the US. AN introduction of appropriate technology and a reduction in oil prices led to increasing supply and also an increased demand for oil-dependent products.