Impact of Oil Prices On American Economy - Assignment Example

Running Head: Impact of Oil Prices on the US Economy MACROECONOMICS The US Economy - Impact of Oil Prices Affiliation: Suddenincreases in the prices of oil have been followed by sharp increase in inflation, followed by 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 or Government is not likely to have a perceptible effect if recession sets in. 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 US and other large economies of the world is remote. Introduction 'There are good reasons to believe that 2006 will be the year when consumers in America and several other economies lose their nerve' (Woodall, P 2006). Over the last five years, US natural gas markets have known three major price shocks and have continued to present extremely high volatility (BNP-Paribas). In the past sudden increases in the prices of oil have been followed by sharp increase in inflation, followed by a recession. Again 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 and take corrective action where possible and required. 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. The discussion of the impact of oil prices on the US economy is divided into two parts in this essay: 1. Analysis of the fallout of the previous oil price shocks to determine how far it can be reasoned that these shocks did indeed cause inflation and recession 2. 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. 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 and the recessions during the same period. There does not seem to be an immediate relationship between the two, but if we factor in other information such as the timing of the interference of the central banks/ Government by adjusting interest rates and other fiscal measures to bolster the economy, the stocks of oil 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. As the development rates of the world economy reach all time highs the recession another oil price hike may cause will be difficult to control, since simultaneously interest rates are already very low and further tightening of money supply would yield very marginal results. Because of the phenomenal growth of the world economy things have become quite different from what was historically normal. Real oil prices have reached twice their average over the past two decades, Bond yields have reached the lowest ever levels, American savings are at record lows while the current-account deficit is at a record high (Woodall P, 2006). Discussion Rise in prices of gasoline hit us all everyday. The macro economic situation is better understood through an examination of the impact of the rise in crude oil prices on the major economies of the world and the US in particular. We will examine the oil market and its effect on the US economy from a supply-demand balance viewpoint. The production function for the economy is simply written as: Y = f (N, K, O) ------ (1) Where Y is the production, N the labour used, K the capital employed and O the price of oil. Capital employed is not variable in the short term it is assumed to be constant. This function has been modified to include the price of oil. The profit function is defined as: Profit = P.Y - W.N - Pk.K - Po.P ------ 2 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. Po being the price of oil and P the quantity of oil used. This equation has been modified to include the effect of oil prices.. Now to increase profit firms 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. The simplest way to do so would seem to be to increase consumption of Oil so that the production increases. Increase in use of Oil has two effects: 1. Profit will increase, since with increase in use of oil the output Y will increase 2. Profit will fall because we now use more oil for which we have to pay 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 (demand) must fall to O2 from O1 because the marginal product of oil remains constant. With the decrease in oil consumption the production will fall. 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. In actual situation the demand does not reduce in response to the increase in prices, it is the price that will drive an overall price rise of all commodities in the marketplace. 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. 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. This evidence presented in Table 1 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) 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 (Chandrasekhar & Ghosh). A case in point is the 2003 Iraq war, 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 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 (PTI). 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 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 References 1. Barsky, Robert & Kiljan, Lutz 'OIL AND THE MACROECONOMY SINCE THE 1970s' Working Paper 10855. Accessed on June 6 2006 from 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. Accessed on June 6 2006 from http://www.imf.org/external/pubs/ft/wp/2001/wp0114.pdf 3. PTI, Press Trust of India. 'Weak dollar threatens world economy'. Accessed on June 6 2006 from http://www.expressindia.com/fullstory.phpnewsid=41220# 4. High Oil prices threaten World economy: FM. September 20, 2005. Accessed on June 7 2006 from http://www.indiainfoline.com/nevi/higp.html. 5. Chandrasekhar C.P. & Ghosh Jayati. 'Oil and the Tenuous Global Balance'. May 5, 2006. Accessed on June 6 2006 from http://www.networkideas.org/news/may2006/news05_Oil.htm 6. Woodall, Pam 'Fragile Foundations' The Economist. Jan 2006. page 15 7. BNP Paribas: 'US Gas Prices Roller-coaster - An analysis of past and future price trends' Accessed on 6 June 2006 from: http://corp.bnpparibas.com/gas-trends-energy-research-natural-gas 8. Robert Barsky and Lutz Kilian 'Oil and the Macroeconomy since the 1970s http://www.nber.org/papers/w10855 Read More