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Hot Gas Prices May Cool the Economy
Subject Gasoline prices
Topic Aggregate Demand / Aggregate Supply
Key Words Recession, Discretionary Income, Economic Growth
News Story

Gasoline prices jumped 15 percent last month, to an average of $1.66 a gallon. Compared to a year ago, gasoline prices are up over 12 percent and many industry experts are predicting that consumers will once again be paying $2.00 a gallon in many areas of the country. Unlike the increases last year, which were dependent on the production decisions of oil producers, much of the blame the recent increases are attributed to a shortage of oil refining capacity. Increases in gasoline prices are much like tax increases, in that they reduce discretionary income and, in the midst of a slowing economy, could throw the economy into recession.

The shortage of refining capacity has many causes. Environmental concerns and opposition form environmental groups have successfully restricted the construction of new refineries. No new refineries have been built in this country since the mid-1970s with the result that there are fewer refineries today than ten years ago. Inventories of gasoline are lagging behind last year's levels, which were historically very low. An added complication is that the refining process is more complex than it was a decade ago. Because of clean air standards, gasoline is reformulated for different parts of the country and because the additives differ, gasoline cannot be easily shipped from one part of the country to another.

Of concern to many economists is how the higher gasoline prices will affect the economy. A 30 percent increase in the price of gasoline reduces consumers' discretionary income by about $24 billion, and lowers economic growth by .5 percent. Because demand for gasoline is relatively inelastic in the short run, consumers will pay the increased prices and will cut expenditures in other areas. With an already sluggish economy, cuts in consumer spending could tip the economy into recession.

(Updated June 1, 2001)

Questions
1.

Show using an aggregate demand/aggregate supply diagram, the U.S. economy at full-employment macroeconomic equilibrium. Carefully indicate the level of real GDP and prices.

2. Show the impact of an increase in gasoline prices on the aggregate supply curve. What happened to aggregate supply? GDP? The price level? Explain.
3. Suppose that policy-makers become concerned about the state of the economy. What would happen if the Fed eased monetary policy? What would happen if the government increased spending?
4. Suppose that the government proposes a policy that emphasizes increased supply of gasoline. What would happen to the short and long-run aggregate supply curves if the policy were successful?
Source Neela Banerjee, "U.S. Gas Prices Soar Again, And Refineries Have No Cure," The New York Times, April 25, 2001.

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