World Oil Prices Collapse
A collapse in world oil prices cuts production costs, shifting SRAS right so the price level falls and real GDP rises.
World Oil Prices Collapse
AD-AS ModelA collapse in world oil prices cuts production costs, shifting SRAS right so the price level falls and real GDP rises.
Equilibrium at Real GDP (Y) 80, Price Level (PL) 60
Long-run equilibrium
The economy starts in long-run equilibrium, where AD meets SRAS on LRAS. Real GDP is at the full-employment level and the price level is stable.
Now try it yourself: shift the curves in a graded FRQ drill, or open this graph in the free sandbox.
Students predict what happens before the graph moves. No accounts, nothing graded.
World Oil Prices Collapse, step by step
- 1
Long-run equilibrium
The economy starts in long-run equilibrium, where AD meets SRAS on LRAS. Real GDP is at the full-employment level and the price level is stable.
- 2
Input costs fall, SRAS shifts right
Oil is an input to nearly everything: shipping, plastics, fertilizer, electricity. When world oil prices collapse, per-unit production costs fall across the economy. Input prices are an SRAS determinant, so firms are willing to produce more at every price level and SRAS shifts right. AD does not move, because nothing has changed C, I, G or Xn.
- 3
Price level falls, real GDP rises
AD now crosses the new SRAS at a lower price level and a higher real GDP. This is the mirror image of stagflation: more output and less inflation at the same time. A favorable supply shock is the one shock that hands policymakers no dilemma, because both of their targets improve together.
- 4
Name the gap carefully
Real GDP has moved past the full-employment level marked by LRAS, so the graph shows an inflationary gap, meaning output above potential. A gap is named for where output sits relative to LRAS, not for which way the price level moved, and that is the trap in this question. Unemployment is now below its natural rate.
- 5
Beyond what the graph shows
The graph stops at the short-run gap. Over time, output above potential tightens the labor market, wages rise, SRAS drifts back left, and real GDP returns to full employment. That adjustment is described here in words and is not drawn on the graph.
Where it ends up
A favorable supply shock shifts SRAS right, so the price level falls while real GDP rises above full employment, which is an inflationary gap even though prices fell.
Now draw it yourself
Same graph, graded on whether you move the right curve and leave the rest alone.
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