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Crude oil prices have recently soared, rising 25% this year to levels not seen since the oil crisis of the early 1980s. 1 At around US$40 per barrel in May 2004, oil costs about four times as much as it did at its low point in late 1998 and is within sight of the record price of US$41. 15 reached during the Gulf War in 1990. 2 This essay will explain the impact of such an event on the Australian economy and its consequences using both the aggregate supply/aggregate demand (AS/AD) model and the aggregate expenditure (AE) models.

We can see from the left table above3 that Australia has been in recent times a net importer of petroleum (crude oil). This means that a rise in world oil prices will cause aggregate domestic supply to fall as products from the fractional distillation of crude oil are factors of production for a wide variety of domestic consumer goods such as plastics, wax and petrol.

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Although the table on the right4 shows that Australia is the second largest consumer of oil per unit of output in the OECD countries, Australia is less vulnerable to higher oil prices than many other countries as domestic production meets most of its needs (refer to table on the left). In fact, a US$10/barrel increase in the oil price would subtract approximately 0. 3% from Australian GDP growth although indirect effects from slower major trading partner growth would also impact negatively on growth. 5 However, these changes in the price of oil nevertheless have an effect on the Australian economy.

Both the AS/AD and AE models of the economy shed some light on what effect of the increase on oil prices has on the domestic economy, but a more complete understanding of the effects is achieved if both models were used in conjunction. The AS/AD model will firstly be used to illustrate the effect of the decrease in AS on the domestic economic equilibrium. The AE model will then be used to demonstrate how the effects suffered by our trading partners due to soaring oil prices affect the Australian economy.

In the AS/AD model, the aforementioned decrease in aggregate domestic supply results in the short run AS line shifting to the left from AS0 to AS1 as shown on the graph on the next page. Also, since the rise in oil prices represents a loss of income to oil consumers in energy-consuming countries such as Australia, it is likely that aggregate demand will now be slightly weaker at all price levels, thus shifting the aggregate demand curve in the model below to the left, albeit not as much as the AS curve.

This result creates a contractionary output gap as an equilibrium with a higher price level and production level below potential GDP is established. Thus rising oil prices causes the economy to experience both inflation and recession – a very unfavourable condition known as stagflation6. Stagflation accentuates the problem with inflation, as high unemployment coupled with high prices leads to a dramatic decrease in living standards. The usual problems of high unemployment, such as lost production, incomes and human capital also plague the economy.

The aggregate expenditure (AE) model also demonstrates why a sudden increase in the world oil price creates a short run economic equilibrium which is below potential GDP, but describes in more detail the role of Australia’s interaction with the international community in achieving the aforementioned outcome. The AE model is based on the premise that in when the economy is in equilibrium (but not necessarily producing at potential GDP).

It can clearly be seen that since Australia is a net importer of crude oil, as its price increases, the cost of Australia’s imports will increase, thus decreasing AE. Also, the decreasing GDP from our trading partners such the United States and Japan due to rising oil prices will decrease our exports, thus further decreasing our AE and thus GDP. Fortunately, we can see from table A1 on the first page that Australia is a net exporter of gas and coal, which are, to an extent, substitutes to crude oil so the negative effect on Australia’s net exports due to rising oil prices is very minor.

The effect of the increase in the cost of imports and the decrease in exports on domestic GDP can be demonstrated diagrammatically as follows: As imports rise from M0 to M1 and exports fall from X0 to X1, the AE curve will shift downwards from AE0 to AE1. As a result, real GDP will decrease from Y0 to Y1 since the economy will always shift to a point where known as equilibrium expenditure where real GDP = AE7.

However, due to the multiplier effect8, the decrease in actual GDP may be many times greater than the actual downward shift of the AE line, as demonstrated in the graph above. In conclusion, even though the Australian economy is fairly robust to increases in the world price of crude oil compared to some other nations, such events will nevertheless have an impact on the domestic economy and depending on the size of the multiplier, the effect may be substantial.

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