Suppose war in the world\'s main oil-producing region sharply reduces the world

Question

Suppose war in the world's main oil-producing region sharply reduces the world oil supply, causing oil prices to rise and increasing the costs of producing goods and services in this economy. The increase in production costs causes a shift from AS1 to AS2, and moves the economy from point A to point B in the short run. (Note: For simplicity, ignore any possible impact of the higher oil prices on the natural rate of output.) The short-run economic outcome resulting from the increase in production costs is known as stagflation. If, during the transition from the short run to the long run, firms and workers respond to the initial shock of higher oil prices by negotiating higher wages, the economy will move from the point you just found to point. In the absence of government intervention, the level of employment and output attained in the short run will eventually begin to put pressure on wages and prices as the economy transitions from the short run to the long run. In the long run, the price level in the economy will be, and the quantity of output in the economy will be billion.

Explanation / Answer

Initially, the economy was in equilibrium at point A, where aggregate demand curve AD1 was intersecting the aggregate supply curve AS1. Price level was 90 and output was 80 billion (This is also the potential output of the economy).

Now, reduction in supply of oil in world market has raised the price of oil. This rise in price of oil has raised the cost of production of firms in given economy. Rising cost of production will reduce the profit-margin of firms and will compel them to reduce production. This will shift the aggregate supply curve from AS1 to AS2. New equilibrium is attained at point B wher AS2 curve is intersecting the AD1 curve. Equilibrium price level is 100 and output is 75 billion. New short-run equilibrium output (75 billion) is less than potential output (80 billion). This indicates recessionary gap and during recession unemployment rises.

So, this economy is experiencing a rise in price level and rise in unemployment rate at the same time. This situation is known as stagflation.

So, the increase in production costs causes a shift from AS1 to AS2, and moves the economy from point A to point B in the short-run.

The short run economic outcome resulting from the increase in production costs is known as stagflation.

If workers negotiates higher wages then this will raise the cost of production further and will bring further reduction in output as well. This will shift the AS curve further left to AS3 from AS2.

New equilibrium will ne attained at point C.

However, at point C, equilibrium output is 70 billion. Thus equilibrium output has decreased further.

This will increase the severity of recession and will increase unemployment and reduce consumption expenditure.

Both these happenings will put downward pressure on wages and prices which in result will lead to rightward shift of AS curve from AS3 to AS2 and AD curve from AD1 to AD2.

New equilibrium is attained at point E with price level 110 and equilibrium output being 80 billion.

So,

If, during the transition from the short run to long run, firms and workers respond to the initial shock of higher oil prices by negotiating higher wages, the economy will move from the point you ust found to point C. In the absence of government intervention, the level of employment and output attained in the short run will eventually begin to put downward pressure on wages and prices as the economy transitions from the short-run to the long run. In the long-run, the price level in the economy will be 110, and the quantity of output in the economy will be 80 billion.

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