Answer to Question #185484 in Macroeconomics for Abu Samad

Question

Suppose, the economy is in both short run & long run equilibrium. The OPEC has decided to raise the oil prise. What will happen to the equilibrium condition of the economy? How the adjustment towards equilibrium will take place? What is the term used for this type of economic situation?

Answer 1

A short-run equilibrium is where the quantity demanded of the real GDP equals the quantity of real GDP supplied; at the point where AD curve intersects with SAS curve while long-rum equilibrium occurs when real GDP equals potential GDP; when the economy is on it LAS curve.

Graphical presentation of economy at:

(i) short - run equilibrium:

(ii) long - run equilibrium:

Effects of oil shock (increase in oil prices):

The effects of the decision by the OPEC to increase the price of oil has both short term and long term impacts on the economy. Short term impacts or effects attributed to oil shock (increase in oil prices) is reduction in on output (Y) owing to inflation i.e. the rise in the cost of inputs or raw materials; as a result of capacity utilization measures taken by producers to maximize profit, resulting in high prices of goods hence decrease in the aggregate demand for CPI commodities as illustrated below (in a graph);

On the other hand, the long-term effects of the oil shock is mainly related to investment reduction as a result of inflationary transmission. Oil shock has a positive effect on interest rates; an increase in the interest rates make the cost of capital goods expensive and coupled with low demand for CPI goods, discourages potential investors and most existing firms resort to downsizing measures and since investment determines the level of output in the long run, reduction in GDP supply out is therefore inevitable.

Adjustments (correction) towards equilibrium:

The needed adjustment towards equilibrium in such a situation wrecked by oil shock include but not limited to the following:

• Producers can mark up their prices to offset the increased input when the short term disadvantageous situation fades away, which is almost quick.
• Price controls measures for both industrial and CPI commodities especially if most inputs are not imported in the country in question.
• In order to mitigate against long term impact, removal of unnecessary price restrictions to improve market structure will be necessary.
• Expanding domestic and export demand to offset cost increase and stimulate output.
• Lowering of interest rates to stimulate investment and counteract the adverse impact.
• Improving energy efficiency and adopting alternative energy sources such as renewable energies through technological and sectoral adjustment.

This situation is referred to as supply shock; an event that makes production across the economy more difficult, more costly, or impossible for at least some industries. A rise in the cost of important commodities such as oil can cause fuel prices to skyrocket, making it expensive to use for business purposes leading to stagflation.