Impact Of Oil Prices On Aggregate Demand And Aggregate Supply Of An Economy

Effect of oil prices on aggregate demand and aggregate supply of an economy

How oil prices affect the AD or AS of an economy?

The modern business environment has witnessed the importance and impact of oil prices upon the world business environment. Oil prices can have a considerable impact on the overall economy of the world. If there is a too much deflation or inflation in the oil prices, then the world economy will suffer, and a financial crisis will take place. There are two types of countries in the world. In addition to this, it can be inferred that the world economy revolves around the transportation and consumption of goods throughout the whole world. In addition to this, there are different types of economic systems that exist throughout the world.  It can also is also inferred that the price of crude oil has fallen to a great extent in comparison with last year. This report will throw on the impact of the falling crude oil prices on the expenses upon the nations who are importing petrol. (Fasenfest, 2014).

Modern economics revolves around the relationship between two major elements. These two elements are demand and supply of goods with its respective prices. Price elasticity plays an effective role while determining the relationship between the given two elements.

The current scenario of the global oil process reflects that the prices of crude oil are on the declining stage. This can be further reflected through the below graph of the trends in crude oil prices.

The above figure suggests about the trends of crude oil prices of the economy. It reflects that the prices of crude oil have come down since the last financial year of 2014-2015. This has a major impact on the petrol importing countries. Oil prices forms the core of all the business economies, whether it is an oil exporting country or oil importing country.

There are several impacts on crude oil prices on the economy of the world. This has a considerable impact on the importers of the substitute product petrol in the world economy. Crude oil forms the core of all commodities throughout the whole world. It can be inferred that the world economy is divided into exporters and importers. The major importers of crude oil are China, India, Australia, Japan, United States, etc. They can have a positive advantage due to the fall of oil prices. This is mainly because the consumption of goods and other household expenditure depends upon the consumption of oil through the oil importing countries. The famous oil shock had a considerable impact upon these oil importing countries. The global financial crisis due to the effect of inflation had a considerable impact on these oil importing countries. There are several elements that the global oil prices have a primary impact. These elements are real income, prices and demands of substitute products and rate of inflation in an economy of oil importing country.

Real income

Real income- This has a negative elasticity with global oil prices in case of oil importing countries. This is mainly because the consumption of household income and household expenses depends upon the oil prices of the economy. Therefore, due to the decrease of global oil prices, the household and consumption expense will increase which have a positive effect on the impact of the real income of the economy (Kilian, 2008).

Prices of Petrol- Due to the decrease of global oil prices, the prices of dependent product petrol will automatically decrease as prices of crude oil decreases. This also have a pivotal impact on the consumption pattern of the household pattern of the importers of petrol.

Rate of inflation- There is a direct relationship between the between prices of crude oils and rate of inflation of an economy. Due to the decrease of crude oils, the rate of inflation will come down as the current account deficient of the countries will come down due to the fall in rate of oil subsidiaries.

Effect on aggregate demand- The impact of aggregate demand of oil importing countries due to the fall of crude oil prices can be explained through the assist of the following table:-

price	Old Demand (quantity)	New demand (Quantity)
100	200	400
95	300	500
85	400	600
75	500	700
10	600	800

Table 1: Impact of decrease of oil prices on aggregate demand

he above table and graph reflects that the due to the decrease of oil prices, the aggregate demand curve shifts to the right. This further reflects that the aggregate demand increases due to the given structure of oil prices (Madureira, 2014).

In addition to this, there are multiple amounts of macroeconomic factors that have a considerable impact due to the rise or fall of oil prices in the given world economy. These macroeconomic factors are a lower rate of inflation in the economy and higher amount of productivity in the total number of output produced. When the oil prices start falling, then, the rate of inflation will also fall as the real income of an economy increases. In addition to this, the total amount of output produced in an economy also increases due to the falling oil prices. The gross domestic product (GDP) of oil importing country will rise as Current Account Deficit of the country will fall due to the increase of per capital income. This will further have a considerable impact on the aggregate supply of petrol (Mankiw and Reis, 2010). The demand for crude oil increases as the households needs to pay less amount of expenditure for electricity as well as driving their cars or consuming different types of goods and services. This can have a major impact on the supply of crude oils as well. This can also be explained with the assist of the below table and graph.

price	Old supply	New supply
100	200	400
95	300	500
85	400	600
75	500	700
10	600	800

Prices of Petrol

Table 2: Impact of decrease of oil prices on aggregate supply

Aggregate supply may be defined as the total amount of total rate at which the goods and services produced at a particular period in a particular economy. It also helps in establishing an effective correlation between the two elements of economics that is, price and the total amount of quantity produced.

It is seen, from the above table and graph, the aggregate supply curve shifts to the right due to the fall in crude oil prices. This further suggests that the supply of crude oil prices increases as the crude oil prices fall. This is mainly because the demand for the oil and petrol increases due to the fallen prices. It further adds up a pivotal impact on the global oil prices. In addition to this, the household and petrol importing countries import more and more crude oil to minimize their balance of trade and balance of payments. On the contrary, it may be also inferred that the petrol exporting countries will have a negative impact due to the given fall in crude oil prices. The major reason behind this is that the profitability and trade surplus will get reduced by a considerable manner (Haase and Zimmermann, 2013)

However, there are several exceptions with regards to the decrease in oil prices and its impact on aggregate demand and aggregate supply. If there are inflation and the higher amount of current account deficit in particular petrol importing country, then the aggregate demand may not change even if the prices of crude oil prices fall. However, on the contrary, in case of countries having a higher amount of current account deficit, then they can easily reduce due to falling crude oil prices with the help of increase of per capital income and rate of gross domestic product. The aggregate demand and aggregate supply of the crude oil importing countries may also depend upon the monetary policy of the respective financial markets of the economy. In addition to this, it can be also inferred that if the monitory policy and valuation of exchange rate are not strong enough and is depreciating, then, the decrease in oil prices may not have a considerable effect on that particular country. Therefore, the exceptional factors that can be considered here is with regards to importing countries are in the form of inflation rate, required monetary policy, current exchange rate and total rate of impact of financial market of the respective economy.

Conclusion

It is concluded that the global oil prices have a huge impact on all the overall world economy. In addition to this, the decrease in crude oil prices has a positive impact on the oil importing countries. This is mainly because, the household incomes and gross domestic product of the importing countries increase as the total number of expenses of the organization decreases. Therefore, the aggregate demand and aggregate supply of the crude oil increases in the oil importing countries.

References

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