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.

*Two paragraphs: 1st on Short Run

2nd on Long Run

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

*Two paragraphs: 1st on Short Run

2nd on Long Run

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

Answer 1;

Increase in the price of oil in the short run will impact the aggregate supply of the economy.This is because since oil is used as a factor of production in the manufacturing of various goods, this will lead to increase in the cost of production of goods. Thus, short run aggregate supply curve of the economy will shift leftwards and thus price level in the economy in the short run will increase and national output of the economy will fall in the short run. The case study also states that the price of oil doubled and there was increase in overall price level during 1973-75.

In the long run automatic adjustment in the economy led to rightwards shift of the aggregate supply curve of the economy. This is because there was rise in the unemployment rate in the short run because of fall in national output of the economy. This led to fall in the wage rate and thus aggregate supply curve of the economy shifted rightwards and thus there was decline in the price level in the long run and economy reached to its potential level of output in the long run.

Thus, in the long run automatic adjustment in the economy helped the economy to reach its potential level of output.