Through successful diplomatic efforts, OPEC agrees to reduce oil prices for the duration of a current international crisis. Assume that economy is operating at its full-employment level of output when the announcement is made. All else being equal, which of the following is most likely to occur based on the aggregate demand/aggregate supply model? a. The long-run aggregate supply curve will shift to the right because of the increase in productivity from the cheaper oil. b. Real interest rates will fall. c. Spending in the economy will increase approximately in proportion to the increase in output brought about the lower oil prices. d. Employment will fall in the short run. - Dinesh S
I am going with C
My guess is A for the following reasons: Since a major distributor of a commodity is lowering price, other producers are willing to produce less. Oil is a bad example because the world will buy all that they can get. I think the example would work better with oranges or wheat. B is wrong because if anything low oil prices will increase demand for other goods…they are cheaper, and this will increase inflation which will put upward pressure on oil prices. C is wrong because of the words “in proportion”. D. is wrong because if anything this would stimulate growth and employment.
I think it is A as well. Not B: Though Nominal interest should fall due to reduced short term inflation. (no change in inflation expectations though) Not C: As the total spending in the economy should probably go down, as the amount saved by consumers due to cheaper oil will be spent based on their propensity to consume. Not D: same reasoning as redbaron ^
For my resonse addressing alternative B, I meant to say it would put upward pressure on interest rates. Sorry for the typo.
I first thought A as well…but then began to question what impact this senerio would have on LONG-RUN aggregate supply since this is a short-run issue… Could be wrong though…
I would say C. AS will decrease shift to right. AD unchanged New equillibrium above full employment. LRAS unchanged. Not A because LRAS shifts if one of the three changes: size of capital full employment quantity of labour technology Not B economy above full employment, higher spending, upward pressure on real interest rate Not D Employmeny will increase. BTW just check this webpage, http://www.whitenova.com/thinkEconomics/index.html It has interactive graphs, so you can play around with them and practice.
I am going with C too. The cartel agrees to reduce price during the crisis (short-term impact). So, A is highly unlikely. The word “approximately in proportion” sounds good in Choice C as well. Dinesh, what’s the answer pls? Cheers.
guys, I so second you all … I had clicked C too, but then the passmaster didn’t agree to it, Then all I could do is paste this question here, blame my Red Bull for overanalyzing things and caught up on my sleep. should I puke out the answer or more of you want to give it another try? - Dinesh S
I think it is A.
“D” -> just for the heck of it. If I had to give a reason: It’s the Short Run. You can’t change the supply of oil. So that takes off OPTION A. The only other way to offer a lower price would be to cut jobs temporarily. This is a flawed explanation lol. But given that C is not the answer, I just took a wild stab at it. I would have also gone with C.
I would have said C too. I also agree with Reema about why it can’t be A. Kevin002 I was under the impression that OPEC could change the supply of oil in the short run. I thought that they controlled oil prices somewhat by restricting supply (at least the portion of production they have control over) Can someone shed light on that?
Show time… Right from Stalla Passmaster… Choice “b” is correct. The reduced oil prices lead to an unexpected short run aggregate supply increase. The economy’s income and output will increase resulting in short-run macroeconomic equilibrium at a higher level of output and employment with lower prices. According to the permanent income hypothesis, however, people will see the income from the expansion as a temporary windfall and save much of it for leaner times in the future. This increases the supply of loanable funds, which in turn reduces the real interest rate. Choice “a” is incorrect. The long-run aggregate supply curve will shift only in response to additions to the resource base, not a change in the price of resources already available. The short-run aggregate supply curve, however, will shift to the right in response to lower resource prices. The long-run aggregate supply curve remains fixed as oil prices fall. Choice “c” is incorrect. The reduced oil prices lead to an unexpected aggregate supply increase. The economy’s income and output will increase resulting in short-run macroeconomic equilibrium at a higher level. According to the permanent income hypothesis, however, people will see the income from the expansion as a temporary windfall and save much of it for leaner times in the future. Spending will increase in the economy but proportionately far less than the increase in income. Choice “d” is incorrect. The lower oil prices shift short-run aggregate supply to the right and increase the short-run macroeconomic equilibrium. This increases output and employment. Note, however, that the new short-run macroeconomic equilibrium is now above the economy’s full-employment level of output. Resource prices increase, causing short-run aggregate supply to shift left until the economy regains equilibrium at the full-employment output level. This long-run adjustment process reduces employment back to its original level, all else remaining constant. Could somebody explain me, what they are trying to imply in ‘B’?? - Dinesh S
Oh actually that makes the lightbulb go off! Okay, so originally there’s the LRAS (vertical line) SRAS (positively sloping) and AD (negatively sloping) curve. They intersect at interest rate = 5% (random number) and full employment. Now if we get a reduction in prices, SRAS will increase (AD will stay relatively constant in the short run because demand for oil/petroleum is relatively inelastic). So make an SRAS(1) curve (positively sloping) shifted to the right to reflect the increase in SRAS from the declining prices — and you’ll see that real interest rates fall to let’s say 4%, at least temporarily. Eventually AD will decrease and the economy will return back to equilibrium in the long run. I can’t believe I didn’t see that before! Is that too confusing, Dinesh? It’s a lot easier to explain graphically. I really need to do more practice questions…
Dennis, you moved the SRAS curve to the right to SRAS(1) position when the price of the oil was down - don’t understand this. Also, when oil was initially costing $85/barrel at LR-equilibrum and all of a sudden you decrease the price to say $70/barrel, people start buying (C component of (C + I + G + Nx) increases) and hence AD should increase, right? - Dinesh S
Well, supply would definitely increase because if the price of oil goes down then more oil can be provided at a given point in time. My reasoning for AD not increasing is because the demand for oil/petroleum is relatively inelastic. Think about it in terms of gas prices…just because gas goes down to 1.34 a gallon doesn’t mean you can buy more than 14 gallons (or whatever your car can take) — so AD stays the same for the short term, but you would still have that shift in the supply curve.
Isn’t the supply of oil or any non-renewable resource elastic. Wouldn’t lowering the price cause supply to go down?
dennis2085, Consider a manufacturing firm, Price of Pens = $4.5, Quanty produced per year=200 Revenue = 900 So now, you saying that, lowering the price to 3, and considering that they still need the same Revenue of $900, they will need to increase their production to 300 per year… Supply increases and curve moves right… Was this the reasoning being the SRAS curve shifting to SRAS(1)? - Dinesh S
That’s a very good way of putting it, Dinesh.
moto376 Wrote: ------------------------------------------------------- > Isn’t the supply of oil or any non-renewable > resource elastic. Wouldn’t lowering the price > cause supply to go down? I second you. Why would suppliers want to supply at a cheaper price…they would rather hold the reserves for use later at a higher price. I remember reading this.