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Low Oil Prices? I don’t think so
Guest Blog by Buck Klemkosky*: As the World Turns
New Age of Supply-Side Economics Part II
The New Age of Supply-side Economics and Policy

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Short-run Supply Shocks and Impacts

In this next discussion we bring together the ideas we have developed about AD and AS. What we do now could be called aggregate market analysis. The purpose of aggregate market analysis is to better understand all the things that impact the two key macroeconomic variables: GDP and the price level. We believe that changes in GDP and the price level are best understood as the result of changes in AD and AS.

To begin the analysis we start with a given position. Let’s assume that this is an equilibrium positionimplying that any past changes have had plenty of time to impact GDP and the price level. Thus they are at rest – there is no tendency for either to change. AS = AD. To add some meat to these bones, think of the initial position being one where real GDP is $11 trillion and the price level is 1.1.

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From this equilibrium position, with AS and AD equal, we now introduce a short-run AS shock and see how the shock impacts real GDP and the price level. This analysis begins just like the ones above. We begin by thinking through how the AS shock affects the output decision. But the analysis proceeds beyond that because once AS changes, we need to talk about the response of AD. The aggregate market analysis integrates all the impacts of a given shock on AD and AS.

Consider an increase in oil prices:

  • Above we showed that this should cause lower AS – that is, the increase in business costs would lead to lower employment and output.
  • If firms began to reduce output, then the market for goods and services is disrupted. AS is now less than AD.
  • This aggregate shortage leads to pressure for the price level to rise
  • A rise in the price level
    • reduces AD towards the lower level of AS
    • it also increases AS somewhat, but not enough to overturn the original decrease.
  • The end result is higher energy prices, a higher national price level, lower AS, lower AD, and lower market equilibrium real GDP.

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Now consider an increase in productivity:

  • A productivity increase is tantamount to a reduction in marginal cost and leads to an increase in employment and output.
  • If firms begin to produce more, AS becomes larger than AD.
  • This surplus leads to a declining price level.
  • The lower price level increases AD
  • The lower price level reduces AS but by less than the original increase.
  • The end result is higher productivity, a lower national price level, higher AS, higher AD, and higher equilibrium real GDP.

Screen Shot 2016-04-24 at 9.26.00 AMShort-run Demand Shocks and Impacts

Now that we have more fully developed the aggregate market analysis we can more completely analyze both supply and demand shocks. For a review of demand shocks return to the notes on aggregate demand, monetary policy, and fiscal policy. One example of a demand shock would be an increase in consumer confidence

Consider next an increase in consumer confidence.

  • The increase in consumer confidence increases AD
  • This causes a shortage that increases the national price level
  • A rise in the price level increases marginal revenue relative to marginal costs and creates the profit incentive for firms to hire more labor and increase output. AS rises.
  • A rise in the price level causes AD to decrease somewhat but by less than original increase.
  • The end result is that confidence is higher, the national price level is higher, AD is higher, AS is higher, and real equilibrium GDP is higher.

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Short-run Demand and Supply Shocks and Impacts

In summary, we used these three examples to show how AS and AD short-run shocks can impact the economy.

By impacting the two key macroeconomic variables, Real GDP and the national price level.

This little theoretical apparatus probably seems somewhat stiff and artificial. The world is a very complex entity and what really happens is clearly a lot more dynamic and interesting. But if we back away from all the noise and chaos and we let all the dust settle, this analysis does a pretty good job of explaining what causes what. If you pay close attention to what journalists and economists write about the macroeconomy, you will see the above stories unfold time and time again.

One further outcome from the three examples shows the great contrast between the effects of AS and AD shocks on prices and real GDP. Notice that AS shocks always cause inverse or opposite movements in prices and real GDP.

  • The wage increase caused prices to rise and real GDP to fall.
  • The productivity increase caused prices to fall and output to rise.
  • If you consider price increases as “bad” and output increases as “good” then you could say that any particular supply shock could be considered as:
    • all bad (cost increase)
    • or all good (productivity increase).
  • This contrasts sharply with AD shocks which are always a mixture of good and bad (a rise in AD causes prices and real GDP to rise; a fall in demand causes prices and real GDP to fall).

Working with the Data – Oil Price increases in 2004

The cover page of the July 2004 edition of the Annual International Economic Trends (of the St. Louis Fed) had this title “Will Oil Prices Choke Growth? (can be found at http://research.stlouisfed.org/publications/aiet/20040701/cover.pdf )

The author, Christopher J. Neely concluded by answering his question with a big NO.

First, note that there is no question that he views oil price increases as adverse shocks that are capable of having large negative impacts on AS and real GDP.

He did not believe that the 2004 increase in oil prices would have a large negative impact for several reasons. He compared several factors in 2004 to time periods in the past when oil shocks did have large impacts.

  • First he noted that these increases in oil prices came as a result of a strong economy and large increases in oil demand.
    • It is harder to damage a strong economy.
  • Second, he noted that while oil prices reached into the range above $40, the increase was small in relative terms.
    • It was nothing like the tripling or quadrupling of oil prices in 1973 and 1979.
  • Third, he found that the U.S. now uses much less oil per dollar of GDP.
    • That is another way of saying that oil is a smaller part of the economy – and thus oil price changes impact AS much less than in the past.
  • Finally he noted that policy makers learned from past experiences how not to react to oil prices.

Gerald Ford, president in 1974, imposed his WIN program – Whip Inflation Now. That policy more than assured a recession in 1974 and 1975. Neely did caution that if tensions in the Middle East worsen, then there is room for further energy dislocations that could increase the negative impacts coming from oil.