Question

Discuss possible effects of an increase in oil prices on the level of output and employment.

Answer 1

Oil demand is inelastic, so the price rise is good news for producers because their revenue will rise. Nonetheless, oil importers should experience higher oil purchase costs. The effects are quite significant because oil is the largest traded commodity. Even rising oil prices could transfer economic / policy control from oil importers to oil exporters.Higher oil prices would result in an increase in the role of oil exporters such as OPEC countries in their current account. The current account status of oil importers (e.g. Germany, China) would deteriorate. Oil exporters will see an increase in reserves of foreign currency that they can use to buy foreign assets. e.g. Arab countries like Saudi Arabia are a major buyer of U.S. securities.

A marked increase in oil prices would lead to a higher level of inflation. This is because the cost of transport for many goods will increase, leading to higher prices. This will be cost-push inflation caused by rising aggregate demand / excess growth, which is quite different from inflation. Consumers will experience a decrease in discretionary income. We face higher costs of travel, but they have no compensation for rising incomes. Higher oil prices can lead to slower economic growth, especially if consumer spending is weak.

Cost-push inflation as a result of rising oil prices is a dilemma for policymakers. Higher inflation typically requires higher interest rates to sustain target inflation. But it may not be necessary to reduce inflation as production could well be well below full employment. Policymakers probably gave too much importance to cost-push inflation at the beginning of 2008, and too little weight to the impending economic downturn.

The demand for oil is inelastic in the short term. This means that a price rise will only result in a small drop in demand. Demand is invaluable since customers want goods based on oil, e.g. their car only runs on gasoline. However, higher oil prices will encourage consumers to diversify consumption in the long term (e.g. buy hydrogen-powered cars, etc.), so demand can become more price elastic in the long run. Manufacturers also began to change their approach after the oil price shock of the 1970s. The fuel efficiency of engines was given more attention by US car manufacturers. It also promoted the production of alternatives to petrol cars