Effect of Higher Oil Prices

A look into the effect of higher oil prices.

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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

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Inflation in 2008 due to higher oil prices.
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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.

Consumers will see a fall in discretionary income. They face higher transport costs, but don’t have the compensation of rising incomes. Higher oil prices can lead to slower economic growth – particularly a problem if consumer spending is weak.

Monetary Policy

Cost-push inflation caused by rising oil prices presents a dilemma to policymakers. 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, policymakers gave too much importance to the cost-push inflation and too little weight to the impending economic downturn.

Long-Term effects of higher prices

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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.) Therefore, in the long-run, demand may become more price elastic.

After the oil price shock of the 1970s, manufacturers also started to change their approach. US car manufacturers paid more attention to the fuel efficiency of engines. It has also created an incentive to develop alternatives to petrol cars

Also, higher oil prices will encourage firms to try and find more oil supplies, even if it is expensive. Since the oil price shock of the 1970s, a new wave of countries began producing oil. In countries, such as Venezuela, Russia and remote places like the Antarctic.

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By on October 20th, 2017

One thought on “Effect of Higher Oil Prices

  1. Maybe so in the Short term ???? But what happens in the medium to long term due to the use and development of alternatives, which then become more cost effective eg. vehicles that are more fuel efficient and reduces the cost of transport??? then the inflation reduces again isn’t it?? I think there is always some form of equilibrium. just look at how the price of oil increased during the Gulf war, without a significant increase in CPI!

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