Relationship between oil price rise and the recession in modern world economy - Essay Example

MACROECONOMICS-OIL PRICES Sudden increases in the prices of oil have been followed by sharp increase in inflation and followed by a recession. There does not seem to be a direct relationship between the two but if other factors are considered a link between rise in oil prices and recessions can be established. The global economy is rising at a very fast pace and any corrective action by central banks is not likely to have a perceptible effect if recession sets in. Rise in oil prices has a definite and direct link with inflation followed by recession. The present situation is different. The dependence of the economy on oil has reduced considerably with the strengthening of the IT and services sectors. Although the rise in prices of oil has been large it has not been sudden and the economies of the major economic powers have adjusted to the change. The rise in oil prices will definitely result in an across the board change in prices and thus inflation rates will continue to be high. However the likelihood of this leading to a recession in the large economies of the world is very remote. Introduction Sudden increases in the prices of oil have been followed by sharp increase in inflation and followed by a recession or stagflation. At present there has been a sharp rise in the prices of oil and it is necessary to understand what effects this can have on the economy on a macro scale and take corrective action where possible and required. A number of studies have been carried out to understand the effect of price shocks. With the experience over the last 40 years it is now possible to arrive at a clearer picture of what effects an oil price shock can have. Economists have developed conceptual frameworks to assist in understanding the effects of a sudden increase in any of the inputs to production, that is, labour and capital. These models can be extended to include the effect of oil price shock to allow analysis of the effects of such an event. It is more difficult to link the collapse of oil prices in 1986 to a reciprocal change in the economy. This report is divided into three parts: 1. To evaluate the conceptual framework advocated by different economists and choose one that suits the oil price shock analysis best 2. Analyse the situations arising out of the previous oil price shocks using the chosen model to determine how far it can be reasoned that these shocks did indeed cause inflation and recession 3. Assess the present situation of continuing high oil prices and attempt to predict what the present sharp increase in oil prices is likely to lead to for the major economies of the world. The political events in the Middle-East, that led to rise in the price of oil, and their relation with the recessions in the US economy, since the first big rise in 1973, are listed in Table 1 enclosed. An examination of this information shows the political events in the Middle East that led to price rise of oil sharply and the recessions during the same period. There does not seem to be an immediate relationship between the two, but if other information is factored in we can begin to draw conclusions. These factors are the timing of the interference of the central banks by cutting interest rates and other fiscal measures to bolster the economy, the stocks of oil that were stockpiled at the time of the rise in prices and also the size and performance of that segment of the economy which is not connected directly to the price of oil (the IT sector being a prime example). Three models for understanding the impact of oil price fluctuations have been assessed. These have very little difference amongst them and, despite differing approaches, converge to the same conclusions. For this study the AS/AD model has been chosen in preference to those developed by Mankiw (2003) and Blanchard and Sheen (2004). As the development rates of the world economy reach all time highs the recession that another oil price hike may cause will be difficult to control by traditional methods, since simultaneously interest rates are already very low and further tightening of money supply would yield very marginal results. The situation, thus, needs to be closely monitored based on the lessons of the past. Discussion The Blanchard and Sheen model works on principles developed by the economists. They determine the wage, price and unemployment levels under different conditions and develop this thinking to infer the effect of price rise of inputs like labour, capital or oil can have in leading to increase in prices (inflation) and thence to recession (reduction in output of the economy GDP) when high prices become unsustainable leading to reduction in production and the GDP. The AS/AD model is quite similar to the Mankiw model and this model is used to illustrate the effect of rise in oil prices on the economy. It is clearly understood that while the different models choose to approach the subject from different directions the results are remarkably consistent. In the Aggregate Supply (AS) and Aggregate Demand (AD) model the production function for the economy is simply written as: Y = f (N,K) Where Y is the production, N the labour used and K the capital employed. Since the capital employed is not variable in the short term it is assumed to be constant for the purpose of understanding effects of sudden increases in the price of oil. This function is further modified to include the price of oil to read Y = f (N, K, O) ------ 1 Meaning, that the production output is a function of the inputs of labour, capital and oil. The profit function is defined as: Profit = P.Y – W.N – Pk.K Where P is the average price in the economy and Y is the output in real terms, W is the wage rate per unit of labour and N the number of units employed in the production process. Pk is the unit cost of capital used in production and K the number of units of capital employed. This equation can now be modified to include the effect of oil prices to read: Profit = P.Y – W.N – Pk.K – Po.P ------ 2 Po being the price of oil and P the quantity of oil used. Now if all the firms wish to increase profit they will have to increase the first element on the right side of the equation, representing the revenue, and reduce the others that together represent the cost of production. To understand the impact of oil prices we will consider the other two functions as constant. (High or low productions shall impact the input of labour substantially but to work simultaneously on both oil and labour variations will make the situation complex and difficult to draw conclusions from). The simplest way to do so would seem to be to increase consumption of Oil O so that the production increases. Increase in use of Oil has two effects: 1. Profit will increase, with increase in use of oil the output Y will increase thereby increasing the first term PY. 2. Profit will fall because we now use more oil for which we have to pay and the cost and the third term on the right hand side will go up. These two effects will balance out at a point where the marginal product of oil matches the real price paid, meaning that as the increment in use of oil leads to higher profit it will continue to be used. Marginal product of oil falls as we use more and more oil, and any increase in oil consumption is only beneficial till such time as the value of the marginal product is more than the real price. The equation 2 above may be differentiated to: ∂Profit/∂O = P. ∂Y/∂O - Po This must be equal to zero when no further changes in the use of oil lead to an increase in profits and just at the point where further increase in the use of oil will actually lead to losses in the business. This shows the change in profit due to change in the use of Oil as: P. ∂Y/∂O - Po = 0 Or, ∂Y/∂O = Po/P This may be represented diagrammatically as under: If Oil prices move up from PO1 to PO2 then the oil consumption must fall to O2 from O1 because the marginal product of oil remains constant. With the decrease in oil consumption the production will fall. This has immediate fallout - to produce less we need less labour. At these lower production levels the other factors do not change namely the capital cost etc. therefore, in order to maintain levels of profitability the price has to be increased. This shows that the increase in oil price leads to inflation. THE AS/AD FRAMEWORK In the above grid we begin with the top right panel where we draw the demand and supply curves for oil on axes representing the price of oil and the quantum of oil consumed. This provides us with an equilibrium point represented by a price P* of oil and a corresponding production extrapolated on the top left panel on to the production function curve. The corresponding production represents the aggregate supply curve which is actually a straight line running vertical in the lower left panel. In this panel we superimpose the aggregate demand AD line. With the changing price levels of oil we trace the shift in the price curves in the lower right panel of the grid. The intersection of the P* line with the price curves extrapolated onto the AS/AD panel indicates the pressure on prices with a change in the price of oil. Ultimately this leads to a lowering of production i.e. the AS line needs to shift to the left to meet the AD line at the point of intersection with the new price line projection, and thus consumption of oil levels to restore equilibrium. Rising prices and lowering production – the classic indicators of recession – result. Bernarke (1983) showed that a rise in oil prices will tend to reduce value added because firms will tend to delay investment decisions as they study the trends to find out if the rise is a part of a trend that will continue in the future or the prices are likely to come down. Industry will also look to divert investment into areas that have a lower element of oil consumption in the production formula. However, the effect of such delay or diversion of capital is very small and not likely to affect prices and inflation to a perceptible level, at least in the short term. Bohi (1989) and Bernarke, Gertler, Watson (1977) studied the impact of the 1973 increase in oil prices on the US economy. They concluded that the recession of 1974 was more probably caused by the Federal Reserves policy response to the inflationary trends which were already obtaining in the economy and which were triggered by the sudden increase in the oil prices. The inflation was met by tightening money supply and interest rates and this lead to the recession. But, whatever the reason, no one argues that the rise in oil prices is not inflationary. Barsky and Kilian (2002) made a study that builds on Gordon (1984) and Rotemberg and Woodsford (1996) that verifies that oil price shocks are ‘unambiguously inflationary’. Following increase in prices of oil and therefore increase in prices all round one would expect stagflation namely a decline in industrial production and a rise in the CPI. That recession should necessarily follow is debatable. High and rising levels of oil prices have been around long enough to give cause for concern. As measured by the price of West Texas Intermediate crude, that reached $75 to the barrel on April 21, 2006 and has remained above the $70 level since. Spot prices of Brent Crude have also risen by more than 40 per over the year ending April 21. Political events in the Middle East and their impact on the oil prices, the magnitude and pattern of the subsequent changes in the price of crude oil vary. The case for an increase in the oil prices following the outbreak of the Iran-Iraq war in late 1980 is strong, but, the data reveals that the apparent effect on the price of oil was quite small compared to the effect of the invasion of Kuwait. This seems rather curious, given that the magnitudes of the production cuts were almost the same with a 7.2 percent and 8.8 percent drop relative to pre-war levels, respectively. For example, most of the 1979 increase in the price of oil occurred more than half a year after the Iranian revolution broke out (but before the outbreak of the Iran-Iraq war in late 1980). Thus, the effect of the production cut during the revolution is not in doubt, but the extent to which the observed temporary production cut after October 1978 is actually related to the rapid oil price increases after May 1979 is not clear. Even more curious is the fact that this particular oil price increase in 1979-80, very much unlike the sharp oil price spike following the 1990 war, occurred in the form of small, but persistent price increases extending over a period of almost two years. It is unclear why the typical response of oil prices to a production cut should look so qualitatively different when the nature of the shock is presumably identical and why these increases only occurred when Iran had resumed oil exports. This evidence argues against the existence of a simple link between war-induced cuts in oil supplies and the price of oil. Instead, the effect of a supply cut will depend very much on the response of other suppliers of oil (including Saudi Arabia as the country with the most spare capacity) and on demand conditions in the oil market, reflecting both the overall macroeconomic environment in the world and the degree of anxiety of oil consumers about future supplies. Moreover, increased uncertainty about future oil supplies may shift the price of oil even in the absence of a war-induced production cut. A case in point is the 2003 Iraq war. By definition, at the time of the oil price increase, no war-related production cutbacks had occurred (nor was there significant damage to oil facilities during the war). Thus, all of the observed oil price increase may be attributed to uncertainty. The 1973 oil price shock took the form of a sharp spike, similar to that of 1990 in magnitude. At first sight, this fact is suggestive of a war-based explanation, but the observed increase in the price of oil in late 1973 and early 1974 shows that the increase occurs only after a delay. It does not appear to be directly related to the October 1973 war or damage to oil facilities in that conflict. In fact, most countries involved in military action – Egypt, Jordan, Syria, Iraq – were not even major oil producers. As shown earlier, neither cartel decisions nor the imposition of oil embargoes nor the effects of political uncertainty on the price of oil are independent of global macroeconomic conditions. The present rise in oil prices has been linked to several reasons: global demand is rising by 1.6 million barrels per day in 2006 relative to 2005 the uncertainty in West Asia resulting from the occupation of Iraq and the stand -off in Iran over the nuclear issue political uncertainty in Nigeria, the battle for control of Yukos in Russia, civil strife in Venezuela and fears of the impact of periodic hurricanes in the Gulf of Mexico Over the last decade, the volume of trading in financial instruments linked to oil or energy-related commodities has increased sharply on both commodity exchanges and in over-the-counter markets Depreciation of the US dollar has also contributed significantly to the rise in oil prices, yet the prices are high in terms of currency neutral SDR terms. Conclusion Increases in oil prices have been held responsible for recessions, periods of excessive inflation, reduced productivity and lower economic growth in the past. The global economy is rising at a very fast pace at the moment and any corrective action by central banks is not likely to have a perceptible effect if recession sets in due to the rise in prices of oil. The present situation is somewhat different from those that were there during or immediately at the beginning of the past recessions. While the demand for oil has risen, this is primarily due the push by emerging economies like China and India, the dependence of the economy on oil has reduced considerably with the strengthening of the IT and services sectors. Although the rise in prices of oil has been large it has not been a sudden spurt and therefore the economies have adjusted to the change. In view of all the discussions abroad it is concluded that the rise in oil prices will definitely result in an across the board change in prices and thus inflation rates will continue to be high. However the likelihood of this leading to a recession in the large economies of the world is very remote. Table 1 The Coincidence of Oil Dates and Recessions after 1972 Business Cycle Peak Events Associated with Subsequent Major Oil Price Increase November 1973 October War and Oil Embargo October 1973-early 1974 January 1980 Iranian Revolution October 1978-February 1979 July 1981 Outbreak of Iran-Iraq War September 1980 July 1990 Invasion of Kuwait August 1990 March 2001 OPEC Meeting March 1999 Source: Robert Barsky and Lutz Kilian ‘Oil and the Macroeconomy since the 1970s http://www.nber.org/papers/w10855 WORKS CITED 1. Barsky, Robert & Kiljan, Lutz ‘OIL AND THE MACROECONOMY SINCE THE 1970s’ Working Paper 10855. Available at http://www.nber.org/papers/w10855 2. Berkman, Pelin, Ouliaris, Sam and Samiei Hossein ‘The Structure of the Oil Market and Causes of High Prices’ September 21, 2005. Available at http://www.imf.org/external/pubs/ft/wp/2001/wp0114.pdf 3. Press Trust of India. ‘Weak dollar threatens world economy’. Available at http://www.expressindia.com/fullstory.php?newsid=41220# 4. High Oil prices threaten World economy: FM. September 20, 2005. Available at http://www.indiainfoline.com/nevi/higp.html. 5. Chandrasekhar C.P. & Ghosh Jayati. ‘Oil and The Tenuous Global Balance’. May 5, 2006. Available at http://www.networkideas.org/news/may2006/news05_Oil.htm Read More