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The spike in oil prices caused by the creation of OPEC in 1973 is the classic...

The spike in oil prices caused by the creation of OPEC in 1973 is the classic case of a negative supply shock. What is the effect on output, unemployment and prices of a negative supply shock? Use charts (AD/AS model) to justify your answer.

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Answer #1

A negative supply shock like the one happened when the OPEC was formed will increase the input price of the goods and services. At a higher input cost the Aggregate supply curve will shift to the left i.e. at a higher cost and lower output. The demand and output will fall and the unemployment will rise in the economy.

In the graph shown, the economy was at equilibrium at point A, the price was P1 and the output was Y1. The AD1 curve meets the SRAS2 and LRAS curve at this point.

After the Crude shock, the supply curve will shift from SRAS2 to SRAS1. The price will increase from P2 to P1 and the output will decrease to Y2 and there will be a recessionary gap in the economy.   

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