Answer to Question #240222 in Economics for suvi

Question

2.2 Assuming a fall in the price of oil, use the AD-AS framework to explain the impact on prices,

employment and income

Answer 1

Aggregate demand - AD - represents the real volume of social production that consumers, businesses, and the government are willing to buy at any possible price level, that is, the sum of all spending on goods and services.

Curve AD shows the relationship between GNP, which is demanded in the economy, and the general level of prices. The character of the AD curve is influenced by a number of factors that can be divided into two groups: price and non-price.

Price factors change the volume of aggregate demand in such a way that they cause movement along the AD curve. These include:

interest rate effect: When the price level rises, consumers and businesses need a large amount of money to make the same purchases. The demand for money is increasing. With a constant volume of money supply, this increases the price for the use of money, that is, the interest rate rises. Firms will reduce the purchase of investment goods, consumers - durable goods (especially on credit). Thus, there will be a reduction in the value of the aggregate demand for the real volume of social production;

wealth effect: the real value of money is a variable quantity. At a higher price level, the real value of money and other financial assets of the population (savings, bank accounts, interest on bonds, etc.) decreases. The population is actually getting poorer and less buying;

effect of import purchases: the volumes of imports and exports, among other things, depending on the ratio of prices in a given country and abroad. With an increase in the price level in a given country, domestic buyers will buy more imported goods instead of domestic ones, and foreigners will buy fewer goods from this country, which will lead to a decrease in the country's exports and reduce the total demand for domestic goods. And vice versa.

Supply shocks can be associated with sharp surges in resource prices (price shocks, for example, an oil shock), with natural disasters leading to the loss of a part of the economy's resources, a significant increase in environmental protection costs, etc. This leads to an increase in production costs (AC ) and the shift of the curve AS.

Consider two options:

Increase in production costs (for example, caused by an increase in resource prices). This leads to a bias of AS1 to AS2. In the economy, the level of prices rises (inflation associated with rising costs), the volume of social production decreases and accordingly employment decreases - stagflation occurs (stagnation + inflation);

Reducing production costs (for example, an increase in labor productivity due to the use of new technologies). This leads to a bias of AS1 to AS3. The volume of social production is growing, prices are decreasing. There is economic growth, an increase in production potential, and an increase in the standard of living of the population.