Debating Aggregate Demand and Aggregate Supply

Question: Describe about the Debating Aggregate Demand and Aggregate Supply? Answer: Introduction Oil price hike is a major concern for the developed as well as developing economies in todays globalised world. Oil is a very important resource for growing an economy, because it is used in almost every step towards development from agriculture to industry. The people of the economy are now more techs savvy. The crude oil to the refined one everything has its demand in different sector in the industry. So the change in the oil price highly affects the economic condition of the developed as well as developing one. If the price of oil increases, it influence the energy producing countries positively as their revenue increases by exporting that oil or the products in which oil is used as a major input. In case of oil importing countries it deteriorates, the conditions of the consumers as the hike in oil price cause an all over inflation in those economies (Ioannides, 2014). Overview Occurring inflation is quite obvious in such countries. Nowadays oil has become the root of the economies. Almost every industry from manufacturing to agricultural, from textile to transport industry the role of oil is inevitable in those businesses. If we consider the agricultural sector, we can see that the oil is used there as an energy resource for pumping, willowing. In the manufacturing sector from hard core machineries to textiles, to run the machines electricity is needed. In the transport sector to rn the vehicles energy is needed. So, all these things ultimately require the oil (Debating Aggregate Demand and Aggregate Supply: Introduction, 2010). Increase in Oil price also influences the food price. The cause of the food inflation is the increase of its production cost as well as transportation cost due to hike in oil price (Ito, 2010). Aggregate supply model The aggregate supply model mainly deals with the effect of change in the supply of output due to change of its price. The effect can be divided in to two ways as par the time span having been considered. One is short run and the other is long run effect. In the long run the aggregate supply curve is vertical but in the short run it is upward sloping. There are mainly four types of model: Sticky price, Sticky wage, Workers misperception, imperfect information. We can explain the fall or rise in oil price using any of these models. But as all these models are useful to picturise the issue of fall or hike in oil price, we can get the clearer picture if we consider the all these four models simultaneously. The relationship of the price of oil with its supply can be depicted as follows: Y= YNATURAL + a(P-PEXPECTED), Where YNATURAL is the natural rate of output produced when all the inputs are used at its normal rates, a is a constant which is greater than zero; P is the price level; PEXPECTED is the expected price level and the Y is the ultimate output level (Lawn, 2006). Research Methodology If we want to study it on one country in particular, at first we have to consider an oil exporting country as here we have consider the supply side of the economy and want to investigate how the economy will be affected if the price will change for the oil. If it falls, obviously the exporting countries will suffer from low revenue by exporting oil. The economic structure of the OPEC countries thus will readily be affected. The data has to be taken in the logarithmic form. The real GDP, national currency exchange rate for that particular country, the real price of oil in there and the total unemployment rate all these variables have to be taken under consideration (OIL PRICE REVIEW, 2010). Positive supply shock: an effective reduction in oil price What we notice in the above diagram that the fall of oil price causes the aggregate supply curve to shift to rightward. Previously the AS1 curve intersects the downward sloping AD1 curve at the point A. Now as the price of oil is reduced it causes to shift the AS curve to the new position AS2. The new equilibrium occurs at the position of B. What we can see in the diagram, is that at the new equilibrium point, price level falls so inflation decreases. Another point is that the output level or the real income level increases than that of the initial situation. The economic interpretation is that the economic development is observed while the real income increases. It accelerates the pace of the economic growth for that particular oil importing nation. Now as the enrgy sector is solely dependent upon the availability of the crude oil, its volatility as the factor cost severely affect the economy. Now as the price of oil falls as in this case, it opens up several employment opportunities. So, we can say that this positive supply shock can reduce the unemployment of Britain as an oil importing nation. But what we observe in the above diagram is that as the time passes the aggregate demand also tries to adjust with the new availability of aggregate supply. We can justify it by Says law. As par that law, supply creates its own demand. Somehow it has been followed here also. As the time passes, in the long run the aggregate demand curve also shifts downward to adjust with the change in the short run. The new equilibrium occurs at the point C. Adverse supply shock: a significant hike in oil price Since lowering, the price is a good thing to the middle class common people so the results of it will not be the major concern for the developing economy. They mainly suffer from the issue of going up the price level of oil.Through the aggregate demand and aggregate supply model here; we represent the situation of a Middle East economy with the light of impact of rise in the oil prices. The model is here being used to analyze what should be the key targets or economic policies to fight with the external shocks. The activity here has been designed to show the role of the aggregate demand and aggregate supply in this kind of situation of the economy. The model used is a simplified one. Models are used to compare the reality with a standard perfect situation (POSSO, 2012). It helps us to diagnose how far the real situation is from the ideal one. It gives the idea about the non-standard ceases also by changing the main variables. It can be checked by varying one or more than one variables, then what happens if the economy gets that kind of shock. It helps to predict the future situation and rectify the economy over time with the method of rational expectation (SHU, 2007). As we go on the deep of the problem, the model becomes more complex, as the availability of information diminishes. An increase in oil prices majorly affects the aggregate supply as the oil is such a product which is used in almost every industry. So hike in oil prices will cause increase in the price of the factor inputs which lie on the economy. So it will cause the aggregate supply schedule to shift rightward so that inflation increases than the initial situation (Steffy, 2011). What we can see in the above diagram is the real national income decreases with the shift of the AS curve to the new position. It is obvious, because as we have discussed earlier that the oil price hike causes the deterioration of the purchasing power of the common people. And here in this diagram fall in real national income refers to the same situation (Acemoglu, Finkelstein and Notowidigdo, 2009). The contraction in the aggregate supply lowers the real income causing a lower economic growth faced by the economy. Now low economic growth causes lack of employment as the prospect of future recruitment is very disappointing in the industry (Zhang et al., 2014). So in case of Britain what we notice in case of increase in oil price is the severe unemployment in the industrial economy, because of the dependency of the modern technology on the energy sector. The economic interpretation is very clear, as each industry is more or less dependent in the energy sector, so this external shock of significant oil price hike causes massive inflation resulting severe unemployment in every sector due to the fall in real national income from Y1 to Y2 (Sachs, 2011). Concluding remarks Here what we can see is that the oil shock severely affects the economic power of any country in the global perspective. The empirical research can be done here considering any of the OPEC countries and can be shown that the how the external shock affects the price level of the crude oil of that country and thereby causes to disbalance the economic structure. So, though change in price of oil externally is a short run phenomenon, still its impact is retained still in the long run. References Debating Aggregate Demand and Aggregate Supply: Introduction. (2010).Review of Radical Political Economics, 42(3), pp.307-307. Ioannides, Y. (2014). 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