Oil-price shocks: Beyond standard aggregate demand/aggregate supply analysis

The author explores the problems of portraying oil-price shocks using the a ggregate demand/aggregate supply model. Although oil-price shocks are the m ost commonly cited examples of aggregate supply shocks, they violate the mo del's assumption of constant relative prices (as acknowledged by the label, "oil-price shocks"). The resulting problems are effectively masked in text book presentations by implicitly assuming that the supply shocks occur in a closed economy. However, the typical discussion is glaringly inaccurate wh en discussing the effects of oil-price shocks on oil-rich countries. Thus, the cogency of the standard model's representation of oil-price shocks on o pen economies is compromised. A simple modification of the model that diffe rentiates between production and absorption goods enables it to better refl ect the effects of oil-price shocks on open economies.