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

The recent fall in the prices of oil have important macroeconomic implications. The oil prices has dropped significantly by over 45 per cent since the coronavirus pandemic in China since January, which is now spread to more than 110 countries. Falling crude oil prices will be decreasing the current account deficit, reducing fiscal deficit and appreciating currency for the oil importing countries, like U.S., and thus cushion and breather the adverse impact of coronavirus and other factors. If sustained, it can result to the global growth and disinflation. Moreover also trigger significant shifts of real income from oil exporters to oil importers, thus will be reducing inflation and strengthening growth in a huge number of oil- importing nations however dampening economic activities in oil-exporting nations. The AD-AS model provides an explanation on the output and price level through the relationship of AD (aggregate demand) and AS (aggregate supply). When the economy faces a negative demand shock scenario; the AD (aggregate demand) moves down and to the left. If the supply curve remains unchanged, then output (i.e. real GDP) will decline and prices and costs will decline. This is deflationary as depicted in the Graph-1. However in the long run when most of the countries will remove the movement restrictions entirely and it will cause an upward spike in oil prices. Higher demand will cause the LRAS to shift towards the right as shown in Graph-2