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CASE STUDY

OIL AND THE ECONOMY

Some of the largest economic fluctuations in the US. economy since 1970 have originated in the oil fields of the Middle East. Crude oil is a key input into the production of many goods and services, and much of the world’s oil comes from Saudi Arabia, Kuwait, and other Middle Eastern countries. When some event (usually political in origin) reduces the supply of crude oil flowing from this region, the price of oil rises around the world. US. firms that make gasoline, tires, and many other products experience rising costs, and they find it less profitable to supply their output of goods and services at any given price level. The result is a leftward shift in the aggregate-supply curve, which in turn leads to stagflation.

The ‘first episode of this sort occurred in the mid 1970s. The countries with large oil reserves got together as members of OPEC, the Organization of Petroleum Exporting Countries. OPEC is a cartel-a group of sellers that attempts to thwart competition and reduce production to raise prices. And indeed, oil prices rose substantially. From 1973 to 1975, oil approximately doubled in price. Oil importing  around the world experienced simultaneous inflation and recession. The US. inflation rate as measured by the CPI exceeded 10 percent for the first time in decades. Unemployment rose from 4.9 percent in 1973 to 8.5 percent in 1975.

Almost tbe same thing bappened a few years later. In the late 1970s, the OPEC countries again restricted the supply of oil to raise the price. From 1978 to 1981, the price of oil more than doubled. Once again, the result was stagflation. Inflation, which had subsided somewhat after the first OPEC event, again rose above 10 percent per year. But because the Fed was not willing to accommodate such a large rise in inflation, a recession was soon to follow. Unemployment rose from about 6 percent in 1978 and 1979 to about 10 percent a few years later.

The world market for oil can also be a source of favorable shifts in aggregate supply. In 1986, squabbling broke out among members of OPEC. Member countries reneged on their agreements to restrict oil production, In the world market for crude oil, prices fell by about half. This fall in oil prices reduced costs to US. firms, which now found it more profitable to supply goods and services at any given price level. As a result, the aggregate-supply curve shifted to the right. The US. economy experienced the opposite of stagflation: Output grew rapidly, unemployment fell, and the inflation rate reached its lowest level in many years.

Nonetheless, it would be premature to conclude that the United States no longer needs to worry about oil prices. Political troubles in the Middle East or greater cooperation among the members of OPEC could always send oil prices higher. And indeed, during. the Iraq war, the price of crude oil did rise significantly. If the rise in oil prices were ever large enough, the macroeconomic result would most likely resemble the: stagflation of the 1970s.

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