Effects of an Increase in Oil Prices - Essay Example

The increase in oil prices has led to an increase in production costs in these industries. Since Sweden is a big importer of oil, this increase will lead to a decrease in output and an increase in the rate of inflation. Since an increase in the inflation rate reduces the level of unemployment, this increase in oil prices will also lead to a reduction in unemployment.

The increase in oil prices causes capital input to reduce since it has become expensive to operate machinery and hence a decrease in the marginal product of labor. This will cause the short-run and long-run aggregate supply curves to shift leftwards. Since the increase does not affect the demand side components, the AD curve will not move. The nominal wages and prices will rise from a low point to a high point. The rise in the price level will lead to a decrease in the real money supply. It will also lead to a rise in interest rates from a lower rate to a higher rate. This is a reduction in the investment factor aggregate demand.

The consumption factor also decreases despite the government expenditure not changing. The shock caused by the supply side is similar to that caused by the demand side, the main difference being that it causes inflation and deflation. In cases where the country would want to treat the shock caused by the supply side as it treats that caused by the demand side by trying to stimulate the economy by using monetary or fiscal policies to shift the aggregate demand curve, it will not succeed. This is because the nominal wages are only sticky downwards and attempting that would cause the inflation to increase further making the economy deteriorate.

In the short run, the aggregate supply curve will move to the left from short-run AS1 to short-run AS2. The intersection between the short run AS2 and AD 1 moves upwards towards the left. At a higher point. At this high point, output decreases, and the price level increases. This forms a short-run equilibrium.

In the long run, the aggregate demand changes to the new output level and price level. Immediately this happens, the AD curve moves along the short-run AS curve up to when the AD curve, the short-run AS curve, and the long-run demand curve intersect. This intersection forms the new equilibrium where the short-run aggregate supply curve equals the aggregate demand curve 2 and the long-run aggregate supply curve. The adverse shock will cause both a decrease in output and an increase in the price level but eventually, it will only lead to an increase in price levels or an increase in the long run. Read More