Suppose that the Organization of Petroleum Exporting Countri

Suppose that the Organization of Petroleum Exporting Countries (OPEC) raises oil prices by 50%. What effect will this have on the U.S. aggregate demand curve? On the U.S. short-run aggregate supply curve?

Solution

When price of an important resource used in production process across economy increases (either directly or indirectly), it leads to rise in overall cost of production and decrease in profitability. This compels the producers to produce less and thus overall supply within economy decreases.

This scenario is referred to as supply shock.

Oil is an important resource and is used directly or indirectly across all production processes in United States.

This increase of 50 percent in oil prices by OPEC will raise the production costs for all producers across United States. This will compel them to decrease production as their profitability will be on downturn due to rising production costs.

The aggregate supply in United States will decrease and US short-run aggregate supply curve will shift leftwards.

Supply shocks do not impact aggregate demand and therefore there will be no impact on US aggregate demand curve of this increase in oil prices by OPEC.