Question

You were asked by a colleague to explain the effects of the sudden fall of oil prices as a result of the COVID-19 crisis. Explain and demonstrate graphically these effects using aggregate demand and aggregate supply analysis. What is your prediction when it comes to the effects both the short-run and long-run?

Answer 1

Decrease in price of oil, an essential input, will decrease production cost, so firms will increase output. Aggregate supply will increase, shifting SRAS curve rightward, decreasing price level and increasing output in short run. Unemployment rate will decrease.

In long run, wages and prices are flexible, so aggregate demand decreases, shifting AD curve leftward, intersecting new SRAS curve at further lower price level and restoring output to initial potential output level. Unemployment rate restores to full-employment level.

In following graph, AD0, LRAS0 and SRAS0 are initial aggregate demand, long-run aggregate supply and short-run aggregate supply curves intersecting at point A with initial price level P0 and real GDP (potential GDP) Y0. Lower oil price shifts SRAS0 rightward to SRAS1, intersecting AD0 at point B with lower price level P1 and higher real GDP Y1 in short run. In long run, AD0 shifts leftward to AD1, intersecting SRAS1 at point C with further lower price level P2 but real GDP being restored at Y0.