Question

How can a higher price of oil create inflation?

Answer 1

It shall be noted that oil is a major input in the economy. It is used in critical activities in the agricultural, manufacturing, and service sector. It is also an important element of consumption.

Consumers Higher prices and lower living standards Economic growth Likely to cause economic growth to slowdown Effect of higher oil prices Inflation Rise in cost-push inflation Investment Firms may cut back on investment Current account Oil importers will see bigger current deficit Long-term incentives Firms will seek to develop alternatives to oil Alternatives Consumers may switch to alternatives

It shall be observed that due to higher oil prices, there is cost-push inflation, higher current account deficit, firms cutting back on investment, and economic slowdown. These effects cumulatively contribute to inflation.

Categorically, a higher oil price leads to higher inflation because of the following reasons:

1) If the price of oil rises, then it will cost more to make plastic, and a plastics company will then pass on some or all of this cost to the consumer, which raises prices and thus creates inflation.

2) Demand for oil is inelastic, therefore the rise in price is good news for producers because they will see an increase in their revenue. Oil importers, however, will experience increased costs of purchasing oil. Because oil is the largest traded commodity, the effects are quite significant. A rising oil price implies higher cost of production, which when passed on to the business and consumers, leads to an increase in the general price level in the economy.

3) A marked rise in oil prices will contribute to a higher inflation level. This is because transport costs will rise leading to higher prices for many goods. This will be cost-push inflation.