The paper "How Oil Prices Affect Economy" is a perfect example of a Macro and Microeconomics Assignment. In later 2014, the sudden decline in the prices of crude oil marked an end to four years of stable prices, which had been pegged at around $105 per barrel. The fall in prices was far greater than the non-oil commodity price indices of 2011 (Bjornland & Thorsrud 2014). The decline further signalled the closing stages of price “ supercycle. ” Indeed, the year 2015 has witnessed low oil prices, and is expected to increase slightly in 2016.
As a consequence, the implications of the sharp decline in oil prices have intensified debate on the oil price impacts on aggregate demand and aggregate supply of the oil exporting country (Baffes et al 2015). This paper examines how oil prices affect the aggregate demand and supply of an economy. Special emphasis is given to Norway, as an oil exporter. Effects of Plummeting Oil Prices on AD and AS The decline in prices of crude oil leads to decreased aggregate demand in the oil-exporting countries. It is important to note that, when the price for oil reduces, the net export in the oil-exporting countries reduces.
This, in turn, reduces the real GDP of a country, thus causing the aggregate demand curve to shift to the left, indicating a decrease in aggregate demand as shown in the diagram below. This perspective has been explored broadly by some scholars (Bjornland and Thorsrud, 2014). Baffes et al. (2015) used the structural vector autoregression (SVAR) model to identify how a decline in oil prices leads to a decline in the aggregate demand of the oil-exporting countries.
According to Kilian (2011), the SVAR consists of the multivariate, linear representation of a vector for examining its own lags, as well as variables, whether as a constant or trend. In the case of oil shocks, they can be used to make identification assumptions in order to separate estimates behaviors of certain economic factors and how they affect the economy. Baffes et al. (2015) used the SVAR model to assess the oil price shocks between 1970 and 2007 and separates oil shocks into three constituents, oil demand, oil supply, and lastly, oil-specific demand shocks that depict precautionary demand linked to market issues such as the supply of oil.
Using the model, he indicated that the decline in prices of oil is connected to a decline in aggregate demand in countries that export oil. In a related review, (Hilde 2000) also used the SVAR model and yielded sufficient data that estimated that the decline in oil prices had adverse demand shocks, which weakened the oil-producing country’ s economy. In another study by Bjornland and Thorsrud (2014), the researchers also used the SVAR model to analyze how oil price shocks affect macroeconomic performance.
They established that when oil price reduces, it leads to a downward shift in the aggregate demand curve in the oil-producing countries. On the other hand, the impact of oil price shocks on the aggregate supply is more involved than simply a rise in the cost of output (Baffes et al 2015). They change a country’ s incentives to use energy resources and change their methods of production (Elwood 2001). Based on the SVAR model, Hilde (2000) also showed that a fall in oil prices tend to have real economic effects, where lower energy price affects the revenue the oil-exporting countries expect from trading in oil.
Ekmekcioglu (2012) also established that aggregate demand is also vulnerable to changes that react to the reduction in the price of oil. Reduction in oil price not only reduces income in the oil-exporting countries but also transfer income to the oil-importing countries (Hilde 2000).
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