Answer to Question #250253 in Macroeconomics for Mehwash Sk

Question

When it comes to understanding inflation, and even other aspects of the business cycle, ecological economists will often emphasize the role of energy, and especially oil, in shaping macroeconomic outcomes. To decide how important oil prices are in shaping macroeconomic outcomes such as inflation, do the following: a. Graph the average annual CPI inflation rate from 1970 to the 2000s (www.bls.gov has the data); graph the world price of oil over the same time period (www.eia.doe.gov has these data); overlay the graphs (this is sometimes called “teardrop analysis”) and move them forward and backward a bit to create leads and lags. What kind of a pattern do you see? b. Use the AD/AS model to analyze the impact of an oil shock on the economy. c. What is the necessary consequence of using fiscal policy to stimulate the economy after a supply-side oil shock? What conclusions do you draw from the analysis?

Answer 1

Solution:

a.). It has an up and down pattern.

The graph is as below:

 

 

 

b.). Oil shock will result in numerous shocks in the economy such as cost shocks and wage shocks. In the short run, a cost shock will affect the aggregate supply curve, causing the AS curve to shift upward and to the left.

A wage shock causes an increase in business costs, which causes the AS curve to shift upwards, causing the price level to rise from P to P1.

 

This will cause AD to contract, and equilibrium will fall to Y1, resulting in a decrease in real output and the potential loss of jobs. As a result, cost shocks can cause serious economic difficulties in the affected country. Oil price increases are always a source of concern because of the general inflationary effects they can cause.

 

This is depicted by the below graph:

 

 

c.). The government uses fiscal policy to stimulate the economy during a period of recession. This can be through lowering taxes and increasing government spending. This increases people’s disposable income hence stimulating consumption and investment. As a result, there will be an increased aggregate demand and the AD will shift to the right, the price level will go down and there will be an increase in Real GDP.

 

 

The analysis has demonstrated how critical oil prices are, an oil shock adversely affects the economy as a whole and hence the importance of having stabilized oil prices.