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Oil Prices' Effect on Supply and Demand

Since fall of 2004, rising oil prices (over $70 per barrel in the Spring of 2006) have frequently ended stock market rallies and led to declines in all major stock indexes.

Draw an AS/AD diagram which shows the effect on the US macroeconomy of oil at $70+/barrel versus oil at $40/barrel.
Label your diagram clearly and explain how higher oil prices impact either AS, AD, or both.

Finally, explain why rising oil prices have negatively impacted US equity markets.

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Solution Preview

The ASAD graph is just a way of visualizing the equilibrium forces in a market. It is similar to the supply and demand graphs you have previously studied. The key to drawing your graph is to realize that oil is an important input into the US economy. Therefore, any increase in its price will cause the AS curve to contract. I have attached a file showing the AS and AD curves before the oil price increase.

Assuming the AD curve doesn't move, when you move the AS curve to the left, what ...

Solution Summary

Use of macroeconomic analysis to determine the effect rising oil prices have on supply and demand.