Question

Oil prices had steadily increased (mostly because of sustained energy demand from developing economies). Depict the effect of higher oil prices in the AD-AS diagram, labeling the short run equilibrium as C. Going from the initial equilibrium A to C, draw your graph so that the outcome of your analysis a recession with (moderate) inflation. [Don't worry about quantitative realism...]

Answer 1

Higher oil price will increase the cost of input, raising production cost. Firms will decrease production and output, lowering short run aggregate supply, which will shift the SRAS curve leftward, leading to higher price level and lower real GDP. This is called stagflation.

In following graph, long-run equilibrium is at point A where AD0 (aggregate demand), LRAS0 (long-run aggregate supply) and SRAS0 (short-run aggregate supply) curves intersect, with long-run price level P0 and real GDP (= Potential GDP) Y0. As oil price rises, SRAS0 shifts left to SRAS1, intersecting AD0 at point C with higher price level P1 and lower real GDP Y1.