Question

Earlier this year, oil prices fell to historic lows. Using the aggregate demand and aggregate supply model from chapter 10, explain the effects of this drop in oil prices on the economy (a) in the short run and (b) in the long run

Answer 1

Oil is an important trading commodity and a fall in its prices always has an impact on the global economy. It would cause a reduction in the transport and fuel costs of the firm and thus could transfer the benefits to the consumers. Thus, it would effectively increase the disposable income and thus enables the consumer to spend the amount for other goods. The fear of an imminent global recession forms one of the major reasons for the fall in oil prices. The recent fall in the prices have been attributed to the global crisis and the pandemic which has forced the world to adopt severe lockdown measures thereby causing a reduction in the international and domestic transport needs which has caused a substantial reduction in the need for oil across the globe.

                               The aggregate supply curve gives the relationship between the price levels and the production in an economy and the aggregate demand curve gives the relationship between the price levels and the total demand of an economy. The following are the effects of the fall in the oil prices in the short run and long run using the aggregate demand and supply model

a) Effects of fall in oil prices in the short run

· It could lead to higher spending on other goods and services and thus could contribute to a better GDP rate

· A lower inflation rate and a better GDP rate would be the result of such a situation

· The above factors could lead to shifting of the aggregate supply curve in the short run to the right which means that the production levels are improving in the economy

· Due to improved real income of the consumers, the consumption levels are also expected to be higher in the short run which means that the short run demand curve would also shift towards the right

b) Effect of fall in oil prices in the long run

· In the longer run, the production levels are restricted to an optimal GDP and hence the demand curve is expected to be somewhat vertical in the long run

· The changes in the aggregate demand in an economy is believed to have only temporary effects on the aggregate supply and hence the aggregate supply curve tends to be vertical in the long run economy

· Only capital, labour and technology are expected to have effect on the long run aggregate supply

Thus, from the above points, it could be concluded that in the short run aggregate supply and demand curves, the effects of the variations of the lower oil prices could be evidently seen as a shift in the curve. But, in the longer run, the curves are expected to flatten as the optimal levels of supply and demand would be reached.