Oil Price Shock
What is Oil Price Shock?
An oil price shock is a sudden, large jump in crude oil prices that raises costs across the economy and shifts short-run aggregate supply left.
An oil price shock works through costs. Oil is an input into transport, plastics, fertilizer and electricity, so when its price jumps the cost of producing almost everything rises and firms supply less at every price level. On the aggregate supply and demand diagram that is a leftward shift of short-run aggregate supply, raising the price level while cutting real output, which is why oil shocks tend to bring inflation and unemployment together. For an oil-importing country there is also an income effect, because money spent on imported oil leaves the country and works like a tax on domestic buyers; exporting countries see the mirror image and gain. The two large shocks of the 1970s, one tied to an export embargo and one to the revolution in Iran, are the textbook cases.
Oil Price Shock: a worked example
Suppose an economy uses about one barrel of oil for every $1,000 of output it produces, and the price of crude rises from $40 to $100 a barrel. Costs then rise by $60 per $1,000 of output, an increase of 6 percent in unit costs. Firms facing that will supply the old quantity only at a price roughly 6 percent higher, so the short-run aggregate supply curve shifts left. If the central bank holds aggregate demand steady, the outcome is a higher price level and lower real output rather than one or the other. A jump to $160 a barrel would be twice the cost increase and roughly twice the shift.
The mistake students make with oil price shock
The common error is to treat an oil shock as a fall in aggregate demand because output drops. Weaker demand would push the price level down, not up, so it cannot explain the inflation that comes with an oil shock; shift short-run aggregate supply left instead. A second slip is assuming every country loses. Oil exporters gain income, so the shock redistributes between countries as well as reducing world output.
Oil Price Shock questions
Why does an oil price shock cause inflation and unemployment at the same time?
An oil price shock raises production costs across the whole economy, which shifts short-run aggregate supply left and moves the price level up while real output moves down. Lower output means firms need fewer workers, so unemployment rises alongside prices. Demand-side shocks cannot do this, because they move prices and output in the same direction.
How should a central bank respond to an oil price shock?
A central bank has to choose which half of the problem to treat, because no single interest rate setting fixes both. Tightening to hold inflation down deepens the fall in output, while easing to protect jobs risks letting the price rise feed into expectations. Most modern central banks try to look past the direct price effect while making sure expected inflation stays anchored.
Are oil price shocks always bad for the economy?
An oil price shock is costly for importing countries but a gain for exporting ones, so it redistributes income rather than only destroying it. Inside an importing country, energy producers gain while energy-using manufacturers and households lose. Sharp falls in the oil price work in reverse, acting like a positive supply shock.
This is the live AD/AS Model sandbox. Drag the curves, or open the full version.
Related terms
Get AP Econ exam tips in your inbox
Occasional emails with study tips, new interactive graphs, and exam-season reminders. Free, no spam.
No spam. Unsubscribe anytime. Read our privacy policy.
Keep track of what you have studied
A free EconLearn account adds progress tracking, your quiz history, and achievements. Studying here is free either way, and there is nothing to pay for as a student.
Create a free accountAlready have one? Sign in
Last updated