Effect of Higher Oil Prices

October 20th, 2009 | oil -

Readers Question: With Oil prices rising towards $100, what are the economic effects of rising oil prices?

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 can even shift economic / political power from oil importers to oil exporters.

Current Account

Higher oil prices will lead to an improvement in the current account position of oil exporters like OPEC countries. It will lead to a deterioration in the current account position of oil importers (e.g. Germany, China). Oil exporters will see an increase in foreign currency reserves which they could use to purchase foreign assets. e.g. Arabic countries, such as Saudi Arabia are an important purchaser of US securities.

Inflation

inflation

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 which is quite different to inflation caused by rising aggregate demand / excess growth.

Monetary Policy

Cost push inflation caused by rising oil prices presents a dilemma to policy makers. Higher inflation usually requires higher interest rates to keep inflation on target. But, to reduce inflation may not be appropriate because output could be well below full employment. Arguably, in early 2008, policy makers gave too much importance to the cost push inflation and too little weight to the impending economic downturn.

Long Term Effects.

In the short term, demand for oil is inelastic. This means a rise in price only causes a small fall in demand. Demand is price inelastic because consumers need oil based products, e.g. their car only runs on petrol. However, in the long term, higher oil prices will encourage consumers to diversify consumption (e.g. buy hydrogen powered cars e.t.c.)

Also, higher oil prices will encourage firms to try and find more oil supplies, even if it is expensive, remote places like the Antarctic.

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