A look into the effect of higher oil prices on economies, firms and consumers.
Effect of Higher Oil Prices on the Economy
Readers Question: With oil prices rising towards $100, what are the economic effects of rising oil prices?
- In the short term, higher oil prices will lead to higher costs of production, increased inflation, and decreased living standards for consumers of oil
- In the long-term, higher oil prices can stimulate investment in oil (and alternative energy sources) and also encourage consumers to seek alternatives (e.g. electric cars.)
Main effects of rising oil prices
Higher revenue for oil producers
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 purchasers of US securities.
Inflation
Higher oil prices will cause an increase in the cost of transport, therefore most goods will increase in prices.
Inflation in 2008 and 2021 were both partly due to higher oil prices.
Oil causes a shift in SRAS
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.
A key issue is whether inflation from higher oil prices will prove temporary or permanent. Often, higher oil prices only cause temporary inflation – e.g. in 2008, inflation rose to 5%, but then fell back towards 0% shortly after.
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, reducing 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 oil prices
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.
Effect of higher oil prices in the 2020s
Higher oil prices in the 2020s, will encourage consumers to look into buying electric cars which don’t need oil. In the 2020s, we have more alternatives to oil than we did in the 1970s and 80s.
Also, in the 2020s, higher oil prices might not have the same impact on stimulating investment in discovering new oil fields. Energy companies are wary about environmental pressures which make oil less attractive than it used to be. Governments may bring in higher carbon taxes or directly encourage less use of oil. Therefore, high oil prices may not cause the surge in investment that we saw back in the 1980s.
Further reading
- Do higher oil prices cause recession?
- Factors affecting oil prices
- Adjusting to oil price shocks
- Effect of falling oil prices
