Answer to Question #121660 in Macroeconomics for Sarah

Question

Earlier this year, oil prices fell to historic lows. Using the aggregate demand and supply model from Chapter- Intro to Economic Fluctuations, explain the effects of this drop in oil prices on the economy in short run and long run

Answer 1

Falling oil prices affects the economic activities and inflation by shifting aggregate demand and supply.

On the supply side, lower oil prices will lead to a decline in the cost of production. The lower cost of production may be passed consumers and hence it will indirectly reduce inflation.

 The lower cost of production will lead to a higher investment. On the demand side, by reducing energy bills, a decline in oil prices raises consumers’ real income and leads to an increase in consumer consumption.

Lower oil prices will help to reduce the cost of living. For instance if a household owns a car or uses other forms of transport reliant on oil. This will make the goods to become cheaper due to lower transport costs.

It is illustrated by the following graph.