Last spring, the COVID-19 pandemic hit the oil industry particularly hard, but it has since recovered. Much of the changes which took place within the industry were changes in the amount of output, as well as shifts in the prices of oil. As we (hopefully) are moving out of the pandemic, more price and quantity changes may arise as demand in some countries is decreasing due to higher infection rates, increasing in others, all the while OPEC+ is trying to target a certain price for its oil. In order to analyze this situation, we can use the IS-LM-PC model.
To start this investigation, we should first understand exactly what the IS-LM-PC model is. For this, we will use our textbook as our main source. To begin, the model is first an extension of our previously defined IS-LM model. What is added here is that in addition to the IS-LM graph, another graph is derived below it, showing output, rather than compared to the real interest rate, compared to the change in the inflation rate. This allows us to see whether the economy is above, at, or below potential output, which would have at (1) a 0% change in the inflation, (2) the natural rate of unemployment, and (3) the natural amount of output, when given a PC curve and an amount of output.
(Blanchard 178)
This is important to be able to derive as the three are quite interconnected: when output rises, the inflation rate tends to increase, whereupon unemployment tends to decrease. As such, given the change in one variable, we can arrive at a semi-accurate prediction of how we should expect the rest of the economy to change in effect, all else equal. The IS-LM-PC model also however connects back to our previous WS-PS model. Should the real wage decrease due to higher markups, this means that for a given output, inflation has increased, causing the PC curve to shift up. This means, that in essence, the IS-LM-PC model is bringing together what we have learned about the IS-LM and WS-PS models, in order to allow us to better understand how the concepts of output, real wage, markups, prices, real interest rate, and unemployment, all are interconnected and help us to explain what we should expect when one variable changes. As such, with the comprehensiveness of the model, we should use it in any situation where a change in one of its variables takes place.
Now, with an understanding of the IS-LM-PC model, we can discuss what the consequences might be if OPEC+ (OPEC member-countries plus a few other oil producers, such as Russia) takes measures to influence the price of oil. At the start of the pandemic, as demand for oil significantly dropped, OPEC+ drastically cut oil production -- by 8 million bpd, in fact -- in order to maintain price stability. However, with recent increases in global demand, OPEC+ has decided to ease these output cuts; between May and July, they plan to increase the current supply by 2.2 million bpd, leaving total output cuts at 5.8 million bpd (“OPEC+ to meet Tuesday,” 2021). This gradual increase in output may have to be done with caution, though, as COVID-19 outbreaks continue to spread across the globe.
The third-largest importer of crude oil is India, but recently, India has experienced an incredibly sharp rise in COVID-19 cases and deaths, leading many to believe that there may be a large decrease in global oil demand (“OPEC+ to Meet Tuesday,” 2021). However, others are less skeptical, and instead believe that global demand will stay on track with past predictions: U.S. demand for oil, as well as other nations that are easing restrictions and opening their economies, will outpace the loss in Indian demand for oil. This optimism has led OPEC+ to stick with their initial plan of gradually increasing oil production in the upcoming months, though they will do so at a rate that’s slower than demand. Altogether, with “‘only a modest production increase outside of OPEC+, and OPEC+ pursuing a cautious approach, we expect the oil market to be undersupplied by 1.5 million barrels per day this year’” (“Oil Rises as OPEC+,” 2021). As this quote suggests, OPEC+’s oil production will cautiously lag behind demand, implying that there will be an increase in the price of oil.
This price increase is equivalent to firms increasing their markups, which, in turn, lowers real wages and increases unemployment. At a given level of output, the increase in firm prices leads to higher inflation. This is equivalent to a shift upwards of the PC curve. To combat the increasing inflation, the central bank will raise the policy rate. On the IS-LM graph, this is equivalent to a shift upwards of the LM curve. With a higher real interest rate, output decreases -- in graphical terms, we are moving left along the IS curve. At the same time, inflation becomes stabilized until the output gap has closed and output is equal to potential output. This is shown by moving down along the new PC curve until we cross the line that signifies zero change in the inflation rate, and, as a result, attain a new lower level of potential output. Ultimately, the IS-LM-PC model suggests to us that an increase in oil prices results in a decrease in output.
This is the relationship that economist Keith Sill wrote about in his 2007 article, “The Macroeconomics of Oil Shocks.” It’s important to note, however, that Sill is referring to large increases in oil price that result from major disruptions in oil supply (e.g., the Iran-Iraq War in the early 1980s). In this current situation, wherein OPEC+ is attempting to recover from the effects of the pandemic, the increase in oil price is unlikely to lead to a permanent decrease in output. As opposed to a price increase due to a dramatic drop in oil supply, this price increase is the result of an increase in oil supply cautiously lagging behind demand. Additionally, this price increase is occurring at a time when the economy is trying to recover from a recession, not while it’s about to move into one. So, while the IS-LM-PC model provides us a framework with which to analyze the effect that oil prices have on output, it’s necessary to bear in mind the context of our analysis.
Works Cited
CNBC. (2021, April 27). Oil rises as OPEC+ seen sticking to policy despite India COVID surge. CNBC. https://www.cnbc.com/2021/04/27/oil-markets-covid-in-india.html.
CNBC. (2021, April 27). OPEC+ to meet Tuesday amid concern about rising virus cases. CNBC.https://www.cnbc.com/2021/04/27/oil-opec-to-meet-tuesday-amid-concern-about-rising-virus-cases-.html.
Sill, K. (2007). The Macroeconomics of Oil Shocks. Business Review, Issue Q1, 21-31.
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