Macroeconomics: Oil Price Stock - Essay Example

Macroeconomics: Theory and Applications Assignment # *** *** EXECUTIVE SUMMARY This paper discusses whether the oils price shocks are responsible for both recessions and increases in the rate of inflation and whether we can expect inflation and recessions in world's major economies if the price of oil remains at or above the level reached during the past 12-18 months. It is a fact that the oil prices have been spiraling in the last two years and at present it has reached 72 US$ per barrel from 40US$ and it has been major cause for concern in all countries, including so called developed countries. It is also a fact that many countries have been witnessing inflationary trends in their economy and are facing negative trend in their 'gross domestic product'. However, how the various economic indicators behave during this short period of 'supply shock' and how they forecast performance or health of the economy in the coming period is the moot question. INTRODUCTION: Inflation may be defined as "state of economy, where there is a general and abnormal rise in price of all goods and services". Recession is a state of economy where there is a "slump in Gross Domestic Product in two or three successive quarters of a year with general price rise or fall". In the short run, when a price of a product which is consumed every sector of the economy which contribute to GDP have suddenly risen, other things remain the same, lead to rising prices all commodities and services, fall in real value of money and slow down of economic growth. This phenomenon is attributed to 'supply shock'. GENERAL CAUSES LEADING TO INFLATION & RECESSION: The causes for inflation are many and there are many schools of thought. The two broad causes for inflation are: Increase in money supply. Scarcity of goods and Services or 'Demand pull inflation' OR 'too much money chasing too few goods' According to Neo-Keynesian economic theory there are three major types of inflation, as part of what Robert J. Gordon calls the "triangle model": Demand pull inflation - inflation due to high demand for GDP and low unemployment, also known as Phillips Curve inflation. Cost push inflation - nowadays termed "supply shock inflation", due to an event such as a sudden increase in the price of oil. Built-in inflation - induced by adaptive expectations, often linked to the "price/wage spiral" because it involves workers trying to keep their wages up with prices and then employers passing higher costs on to consumers as higher prices as part of a "vicious circle". Built-in inflation reflects events in the past, and so might be seen as hangover inflation. It is also known as "inertial" inflation, "inflationary momentum", and even "structural inflation. SUPPLY SHOCK INFLATION OR COST PUSH INFLATION: Cost Push inflation or Supply Shock inflation is caused by the rise in price of an important commodity for which there was no alternative, and consequent of which there was a general rise in price of all commodities and services. While the examples for cost push inflation are many viz., failure of monsoon/draught in an agrobased economy which would shoot up inflation etc.,. the best example in the modern industrialised countries, is rise in prices of petroleum prodoucts. Dependence to petroleum products in any economy need not be emphasised and it may not be forgotten that the crisis faced by the world in the year 1970 is attributed to the rise in oil prices all over the world. Since, petroluem is important for moving the economy in all industrial including agricultural dependent countries, any upward movement in the price will cause a cascading movement in the price of all commodities and services and it will have persistant effect. However, there are different school of thought which opine, that the reduction in oil price after 1970 have not contributed in reduction in general price level, hence, rise in oil prices have not directly caused inflation in 1970. However, Keynesian economists argue that many prices are 'sticky downward' or downward inflexible, hence, price reduction is not always possible and down ward trend may not be reflected and it was opined that though there was no deflation after 1970, there was noticeable fall in general price level or CPI. The great depression of 1930 was attributed to "lack of demand" by J.M. Keynes. Further, rise in oil prices may not necessarily be causative factor leading inflation/recession in following circumstances: When the Country's economy has alternative energy sources and not entirely depends on imported oil. Economy is agriculture oriented. Contribution from Service Sector to GDP is very high. Have favourable balance of trade with high reserves of foreign exchange from service sector. However, it may be conveniently concluded that any increase in oil price will definitely cause inflationary /recession conditions at least in the short term. When, we talk about short term phenomenon, in the words of 'Milton Friedman', "there is always a temporary trade off between inflation and unemployment. There is no permanent trade off and the temporary trade off is with the unanticipated rising rate of inflation". In other words, it is emphasized here that in the short run when the aggregate supply curve turn rigid and slopes upward which implies trade off between two macro economic measures, i.e., unemployment and inflation. In order to contain inflation, unemployment has to be maintained and for providing employment, certain degree of inflation needs to be tolerated. In order to understand the behaviour of economic indicators during the short run, it is vital to recollect that the economy is in a state of equilibrium, as per Keynesian model, when aggregate supply curve meets aggregate demand curve. In other words, AGGREGATE DEMAND = AGGREGATE SUPPLY In the short run, in the present scenario, the demand is not altered and there is no exogenous factor affecting the aggregate demand curve. Money supply remains the same. However, the aggregate supply of oil is restricted by way of cut in production & supply imposed by OPEC and the price of the oil is increased. While the aggregate supply curve in the long run is vertical, in the short run it slopes upwards, i.e., the supply increases with price rise. In other words, when the aggregate supply curve is vertical, shifts in the demand curve determines price and when aggregate supply curve slopes upwards, any upward movement in the demand would multiply the price rise. This scenario is best explained in the Sticky Price Model of Aggregate Supply. There are three prominent models to study the behaviour of aggregate supply curve in the short run and in all of them some market imperfection causes temporary disequilibrium. Although each of the three models takes us down through different theoretical route, each route ends up in the same place and the final destination is a short run aggregate supply curve equation of the form: Where Y is out put, is the natural rate of output, P is the price level and Pe is the expected price level. This equation states that output deviates from its natural rate when the price level deviates from the expected price level. The parameter indicates how much out put responds to unexpected changes in the price level 1/ is the slope of the aggregate supply curve. STICKY WAGE MODEL: This model demonstrates how a sticky wages influence the behaviour of aggregate supply curve in the short run. In the short run wages are sticky and rigid and will not adjust quickly when the economic conditions change. It is presumed that the following three things happen to the aggregate supply curve when there was a general price rise: 1. when there was rise in the general price rise, the real wages of labour fall. 2. the lower real wages induce induction of more labour 3. more labour means more production. This positive relationship between the price level and the amount of out put means that the aggregate supply curve slopes upward during the time when the nominal wages cannot adjust. In the model an unexpected rise in prices lower the real wages and thereby raises the quantity of labour hired and the amount of output produced. Most economists opine that this model does not explain fully the short run behaviour of the aggregate supply curve. They advocate models in which labour demand curve shift over the business cycles consequent to technology etc., THE IMPERFECT INFORMATION MODEL: The second model is the imperfect information model in which the short run and long run aggregate supply curve differs because of temporary misperceptions about the prices. The imperfect information model assumes that each manufacturer produces a single good and consumes many goods. Because the number of goods is so large, they could not monitor the prices of the goods they consume, however, the price of the goods which they produce they were monitoring closely. Because of this imperfect information they, some times get confused in the prices of the other goods they consume, which causes disruptions in the goods they supply or deviations in the supply curve. To sum up, the imperfect information model says when the actual price exceed expected price, suppliers exceed the output. Output deviates from the natural rate when the price level deviates from expected price level. STICKY PRICE MODEL: The Sticky Price Model emphasises the firms do not instantly adjust the price they charge in response to the change in demand. The scenario here, is not perfect competition, where demand will determine the price, where as the individual firms fix the price/enter into long term contract/ or they themselves fix the price taking into account their cost and overall price level. When firms expect high price level, they expect high costs and hence fix high prices. These high prices cause other firms to fix high prices. Hence, high expected price leads to actual high price. When the demand is high, output for the goods is high and firms with flexible price option fixes the price high and are able to influence the aggregate supply curve. Of the above three models of aggregate supply curve, the sticky price model gives more plausible explanation to the behaviour of short run aggregate supply curve of petroleum in the present scenario. Although the other two models also contribute to some extent. In the present scenario, the OPEC enter into long term contract or they themselves fix high price taking into account their cost and overall price level of the goods and services which they are interested to buy. For example, for Iran, the price of oil should not only take into account the cost incurred + profit, but also the price of agricultural goods/ military equipments/and other goods which they intend to import from other countries. Therefore, Iran would fix the price of their export product and the quantity of export, viz., oil in such a way it was able to meet its financial requirement. And the countries, who import oil and export agricultural commodities /other requirements, would also attempt to fix the price of their commodities to enable them to pay for the import of required oil. Further, in respect of oil importing countries, the increased price paid to the imported oil would lead to cost-push/supply shock inflation. The economy is in a state of equilibrium when the aggregate supply is equal to aggregate demand. However, now the sudden rise in the import price of oil with restricted supply, the demand for oil is also moving upward given the nature of the product. This will lead to increased cost of production of all goods and services with reduction in supply of goods and services that can be sustained at any given price level. In addition, rise in oil prices would result in reduction of real income thereby affecting aggregate demand which would cause cyclical reaction, low demand , low production, low employment, low income, etc., REASONS FOR SPURT IN OIL PRICES & ITS IMPACT ON AUSTRALIA: As per Monthly Bulletin of the Reserve Bank of Australia for the month of Oct.2004, the demand for oil has been increasing and the OPEC has very less excess capacity. The production of oil from non-OPEC has also been on increase and Russia been the largest contributor. The total spare capacity maintained by OPEC is less than percent of the total demand. Hence, it is opined by the Report that the rise in price of oil is not due to physical restriction of supply. Further, the following non-economic reasons were attributed to the recent uptrend in global oil prices: post-war slow recovery of Iraq oil production terrorist attacks on Saudi oil reserves financial difficulties of largest Russian oil company viz., Yukos other reasons viz., tensions in Venezula, Nigeria and hurricane in Mexican gulf fall in US dollar value Irrespective of the causes, spurt in oil prices generally will lead to inflation and recession. However, the monthly Bulletin of the Reserve Bank of Australia forecast that the present rise in oil prises will not lead to a similar crisis of 1970 in view of the following: the current level of oil prices is not high in real terms as it was during the crisis of 1970 . the energy intensity of the aggregate world out put is lower. The present inflationary level is very low and hence have sufficient cushion to bear further general price rise. As it is felt that the present rise is demand driven and economic conditions of other countries are also favourable, the economy will not face a similar crisis of 1970. Further, Australia is recognised more as a energy exporter than an energy importer. In this regard the following table is self explanatory: AUSTRALIA'S TRADE IN ENERGY RESOURCES- 2003/04 $ IN BILLION COMMODITY EXPORTS IMPORTS PETROLEUM 6.6 10.0 GAS 208 0.2 COAL 11.0 0.0 SOURCE: ABS CAT.NO.5368 It may be seen that, while Australia is a small net importer of oil, its export of other energy yielding commodities, viz., coal and natural gas are substantially high and their prices are linked with oil prices, hence any rise in prices of petroleum is directly related to the price of these export products. Therefore, increased oil prices will not have any repercussions in the Country's exchange rate rather it may strengthen Australian Dollar against other currencies. However, it is pertinent to note that higher import petroleum prices would mean rise domestic fuel price for transport/cars thereby reducing the real value of the money and lesser demand for other products and the country's exports may not perform well due to Australian Dollar appreciation against other currencies and lack of demand if global growth is affected by the high oil prices. In view of the fore going, the primary of effect (rise in CPI) of rise in price of oil on Australian economy is negligible and the secondary effect may be contained though there may be significant effect on wage level. In short, the Australian economy would not be adversely affected even if the price of oil remains at or above the level reached during the past 12-18 months. IMPACT OF SUPPLY SHOCK ON WORLD'S MAJOR ECOMIES: As per the World Bank report on "prospects for global economy", "the most important potential risk stems from the oil market". With the global demand and supply are projected to increase broadly in steep, excess capacity (currently estimated at 1.9 million barrels per day) will remain very constrained and prices could remain at current levels, further rise or even fall. Further, it has projected that the price of the oil may go up to 120$ per barrel and finally settle at 40$ in the year 2009. 2006 2007 2008 2009 Price of Oil Level 90.0 70.1 44.2 40.0 change from base line 34.0 28.0 3.0 0.0 Change in GDP (Change in levels, % of GDP) World -1.0 -1.5 -1.1 0.2 High Income Countries -0.7 -1.3 -1.3 -0.3 Middle income -1.7 -1.6 -0.2 1.4 Large low income -1.7 -2.8 -1.8 0.7 Inflation rate (Change in rates, percentage points) World 2.6 0.6 -1.0 -0.2 High Income Countries 1.4 0.1 -1.0 -0.4 Middle income 5.8 2.0 -0.9 0.5 Large low income 2.8 0.9 -0.7 -0.2 Real interest rates (Change in levels, percentage points) World 1.0 0.2 -0.1 0.1 High Income Countries 1.0 0.1 -0.2 0.0 Middle income 1.1 0.7 0.2 0.2 Large low income 0.5 0.1 0.1 0.4 Impact on Current account balance (% of GDP) World -1.1 -0.5 -0.1 -0.1 High Income Countries -1.1 -0.7 -0.2 -0.2 Middle income -0.9 -0.2 -0.5 -0.3 Large low income -2.0 -0.2 1.8 1.0 Impacts on low-income CA constrained countries (% of GDP) Terms of trade -4.1 .. .. .. GDP growth -0.3 0.1 0.0 .. Domestic Demand - contrib. to gr. -2.7 -1.1 0.0 .. Current account balance -1.2 0.9 0.0 .. Source:WORLD BANK. 2005 2006 2007 2008 Interest rates (% point change of Q4 level from baseline) World 1.8 1.4 -0.6 0.2 High Income Countries 1.7 1.1 -1.1 -0.3 Low and middle income 2.0 2.8 1.9 2.6 Real GDP (% change from baseline) World -0.1 -1.7 -2.9 -1.9 High Income Countries 0.0 -1.5 -2.7 -2.5 Low and middle income -0.2 -2.4 -3.5 -3.0 Inflation (change in inflation rate) World 0.0 -0.3 -1.2 -1.1 High Income Countries 0.0 -0.3 -1.5 -1.6 Low and middle income 0.0 -0.3 0.7 1.2 Source:WorldBank (http://web.worldbank.org/external/default/maintheSitePK=612501&contentMDK=20665787&menuPK=1883085&pagePK=64218950&piPK=64218883) From the above two tables, the projected oil prices, % of rise in inflation rates, fall in GDP( indicator of recession), interest rates and current account balance with reference to GDP, may studied, which will throw more light on our studying the impact of supply shock. IMF REPORT ON GLOBAL IMBALANCES DUE TO SUPPLY SHOCK.: For oil importers: The rise in import prices will worsen the trade balances and foreign exchange reserves thereby reducing the private disposable income, savings, investment, corporate profit and current account deficit. This will lead to monetary tightening that could lead to more pronounced slow growth. For oil exporters: For oil exporters, the process works broadly in reverse. Trade surpluses are offset by stronger growth and overtime, real exchange rate appreciation. One importance difference, however, is that fuel exporters may take longer than fuel importers to adjust to the increase in fuel prices. Hence their savings may remain at high level for extended periods. However, study conducted in this regard reveals that larger part of the savings were utilized for debt repayment and remained as savings reducing the pressure on interest rates and leaving no room for pushing up the aggregate global demand. General: "Global imbalances have emerged prior to oil supply shock and although oil supply shock have contributed further to it. The increase in oil prices since 2003 has directly worsened the US current account deficit by over 1 % pf GDP; at the same time, higher oil prices have tended to reduce surpluses in non-oil -exporting developing countries, notably in Asia. To the extent that higher net savings by oil exporters have driven down global interest rates, and that these lower rates have boosted demand in economies with market based financial systems, such as the United States, the oil price shock may also have had an additional indirect negative effect on the US external position."(IMF REPORT- "World Economic outlook"- April'06)(http://www.imf.org/external/pubs/ft/weo/2006/01/pdf/c2.pdf) CONCLUSION: In the foregoing in brief, we have discussed the definition of inflation; recession; various types of inflation; causes and effect of supply shock inflation; the economic indicators of such supply shock inflation etc. Further, we have also seen that in respect of Australia, the negative impact in growth due to supply shock is very minimal and negligible. The World Bank Report on rise in oil prices and its effect has also thrown more light on comparative study of economic indicators due to supply shock. The IMF report also endorsed the World Bank report. In view of the fore going, it may be concluded that oils price shocks are responsible for both recessions and increases in the rate of inflation and we can expect inflation and recessions in world's major economies if the price of oil remains at or above the level reached during the past 12-18 months. ***** ***** References: Dornbusch R., Bodman P., Crosby M., Fischer S. & Startz R. (2002), Macroeconomics, (1st or 2nd edition)Sydney: McGraw Hill, Chs 5 & 6. Mankiw N.G. (2003), Macroeconomics, 5th edition, New York: Worth Publishers, Ch.13. Blanchard O. & Sheen J. (2004), Macroeconomics, Australasian edition, Sydney: Pearson- Prentice -Hall, pp.124-133; 143-145. Dickman A. & Holloway J. (2004), "Oil Market Developments and Macroeconomic Implications", Reserve Bank of Australia Bulletin, October, pp. 1-8. Reserve Bank of Australia (2005), Statement on Monetary Policy, November 7, pp. 1-3,15-16 and 51-58. Woodall P.(2005), "Fragile Foundations", in Franklin D. (ed.), The World in 2006, London:The EconomistNewspaper, pp.15-16. Barsky R.B. & Kilian L. (2004), "Oil and the Macroeconomy", Journal of Economic Perspectives, 18 (4), pp.115-134. International Monetary Fund- World Economic Outlook- April'2006- Chapter II- 'Oil Prices and global imbalances. - Available on line (http://www.imf.org/external/pubs/ft/weo/2006/01/pdf/c2.pdf World Bank Report - "Prospects for the Global Economy"- 'An Oil-market supply shock could cause serious disruption' - Available on line. (http://web.worldbank.org/external/default/maintheSitePK=612501&contentMDK=20665787&menuPK=1883085&pagePK=64218950&piPK=64218883) Read More