Case Study

Some of the largest economic fluctuations in the U.S. economy since 1970 have originated in the oil fields of the Middle East. Crude oil is a key input into the production of many goods and services, and much of the world's oil comes from Saudi Arabia, Kuwait and other Middle Eastern countries. When some event (usually political in origin) reduces the supply of crude oil flowing from this region, the price of oil rises around the world. U.S. firms that produce gasoline, tires, and many other products experience rising costs, and they find it less profitable to supply their output of goods and services at any given price level. The first episode of this sort occurred in the mid-1970s. The countries with large oil reserves got together as members of OPEC (the Organization of Petroleum Exporting Countries). OPEC reduced production and oil approximately doubled in price from 1973 to 1975.

Almost the same thing happened a few years later. In the late 1970s, the OPEC countries again restricted the supply of oil to raise the price. From 1978 to 1981, the price of oil more than doubled. In 1986, squabbling broke out among members of OPEC. Member countries reneged on their agreements to restrict oil production. In the world market for crude oil, prices fell by a half. This fall in oil prices reduced costs to U.S. firms. In recent years, the world market for oil has not been as important a source of economic fluctuations. Part of the reason is that conservation efforts and changes in technology have reduced the economy's dependence on oil.

a. Explain the short-run and long-run impacts of oil price increase on output and price level in the U.S. during 1973-1975 periods using the model of aggregate demand and aggregate supply. No need to draw the AD-AS diagram. Explain in words.

b. Explain the short-run and long-run impacts of oil price fall on output and price level in the U.S. in 1986, using the model of aggregate demand and aggregate supply. No need to draw the AD-AS diagram. Explain in words.