Inflation and Oil Prices

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Inlfation and Oil Prices Inflation refers to persistent increase in the price level over time and is one of the most dangerous threats to an economy because if unchecked it will erode the purchasing power of a currency and if the monetary system of the country is destroyed, can ultimateky force the indivduals to adopt foreign currency. There are two kinds of Inflation: Demand Pull and Cost Push Inflation. Cost Push Inflation: A situation when inlfation persists in the economy becuase of initial decrease in aggregate suppky caused by an increase in the rela price of an important factor of production i.e wgaes and energy. Oil Crisis of 1970 is a suitable example of cost-push(supply shock ) inflation. Answer 1) Short Run Aggregate Supply is the relationship between Real GDP and the Price Level. In other words, it shows how much the economy can produce in the short run. An increase in price level of oil in the short run will force the producers to reduce the supply of oil in the economy . Following diagram will suitably explain the effect of rise in oil prices on Short Run Aggregate Supply: SRAS’’ SRAS Demand The above figure shows that when the price of oil increases, producers will shft the supply backwards on account of high input prices. As a result, real GDP falls and price level rises and a serious situation of Stagflation is created. Answer 2) Increasing price of oil will be a serious cocnern for the consumers also. Working on the law of demand, as the price of oil increases, the consumers of oil related products i.e gasoline, will reduce their demand at higher prices. Thus,as a result their consumption of oil for driving, burning and production wil be curtailed. (Prasodjo) Answer 3) As we haev alread... ... middle of paper ... ...DP and Unemployment Levels. The AS-AD model shows a negative relationship between level of inflation and unemployment. In other words, with supply shocks because of rise in oil prices, a fall in GDP rate is experienced and this increases the unemployment rates. So higher prices of oil will not only lead to high inflation but also high unemployment and reduced economic growth. This same effect is shown in the Philips Curve. (Parkin) Works Cited Federal Reserve bank of San Fransisco. What are the possible causes and consequences of higher oil prices on the overall economy. November 2007. Web. 14 December 2013. Parkin, Michael. "US Inflation, Unemployment and Business Cycles." Institute, CFA. Economics. Boston: Custom, 2011. 188-210. Print. Prasodjo, Darmawan. Oil Price Analysis: Supply, Demand, and Futures Trading. December 2013. Web. 14 December 2013.

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