Question

Suppose the price of barrel of oil increases from $50 to $70. Use a basic aggregate demand and aggregate supply diagram to show the short-run and long-run effects on the economy.

Answer 1

The graph above represents an economy importing oil. Initially, the economy was in equilibrium at point E, the short run aggregate demand SRAD curve meets the short-run aggregate supply curve SRAS with the long run aggregate supply curve LRAS. The price is P'' and quantity produced at this point is Q.

An increase in the oil price will come as a supply shock for the economy and it will shift the aggregate supply curve to the left at a higher price and lower quantity produced and create a recessionary gap. In the long run, the demand will come back again at the equilibrium level because of increase in wages and compensation to other variables. This will shift the Aggregate demand curve to the right as SRAD' and meet LRAS and SRAS' at E. At a much higher price of P. The long-run output will be at the same level Q.