How Oil Prices Affect The AD Or AS Of An Economy

Cause and effects: overview

How oil prices affect the AD or AS of an economy?

 Please select one of the below:

•  The petrol exporting nations

•  Petrol importing nations

Price of oil is a major issue of concern for every economy from its exporter to its importers. It is the key which controls the economy’s growth and prospect directly or indirectly. If the price of oil increases, it influence the energy producing countries positively as their revenue increases by exporting that oil or the products in which oil is used as a major input. In case of oil importing countries it deteriorates, the conditions of the consumers as the hike in oil price cause an all over inflation in those economies(Davis, 2003).

The reasons behind this inflation are obvious. Oil is the base of any economy. From transport industry to the manufacturing, the role of oil dominates their position that whether they will be beneficial for the common people or not. In case of agriculture, there is need for this oil as the energy used in there to pumping, willowing all are the results of using the electricity or any kind of energy. Moreover, to produce this energy to boost it up the role of oil is inevitable. The hike in the oil price causes the increase in the cost of transportation as different kind of petroleum products is used as the fuel (Ioannides, 2014). Therefore, if the price of petrol, diesel increases it will cause to increase the transportation cost also. Now transportation is a very big issue of concern, as it is inevitable from regular office goers to farmers to industrialists to teachers etc (Debating Aggregate Demand and Aggregate Demand: Introduction, 2010).

Increase in oil price also causes the food inflation as the cost of production increases due to hike in oil price. It influences the people of the economy hampering their purchasing power parity, because their income does not rise with the increase in the price level they face in the food market (Ito, 2010).

Here we consider the issues of the oil importing countries and analyze how their aggregate demand and aggregate demand is getting affected with the rise or fall in oil prices. One of the major oil importing country is United Kingdom. So let us concentrate on this economy’s difficulties with change in the price of oil (Lawn, 2006).

In the short run, the aggregate demand curve is downward sloping and aggregate supply curve is upward sloping. Short run equilibrium occurs at the point where the two lines coincide with each other. The locus of the points of short run equilibrium is termed as the long run aggregate supply curve. It is the responsibility of the policy makers to take the proper expansionary or contractionary policy as par the fall or hike in oil prices to provide the common people a stable economic condition (Nakano, 2004).

Issues of the Oil importing nations

The current economic condition of the economy refers to the situation causing the economy to boost up because the recently a downfall has been noticed in the recent oil price. So it affects the economy of UK in both ways. For the consumers and the manufacturers as well as transport authorities, it seemed to be good news. However, in case of oil and gas extraction sector has been hampered a lot for this fall (OIL PRICE REVIEW, 2010).

If we consider the economic activities of UK, we can see that the business like air transport, road transport, and refined oil petroleum based industries, and the manufacturing sectors producing oil intensive products are getting benefits as their cost of productions getting low as the prices of oil falls. It results in lowering inflation and it creates massive employment (Oil Price Review, 2013).

Now if we consider the sector of oil and gas extraction, we get that, it is severely affected due to the fall in prices of oil.

Here volatility of oil prices is considered the external shock and government should take the remedial policies to get over the situation (Pandey, n.d.).

 The rise in the oil prices are the one of the major cause of slowing down the growth in the oil importing countries. The terms of trade of those countries fall down due to this price hike. It implies that the cost of each unit of import is more than the domestic earning from the each unit of export. So the size of the price hike and the time duration of it affects the aggregate demand of the economy.

 It has been empirically noticed that the economic situation was more affected in the 1973-74 or 78-80,  than that of mid 90 crisis. The cotractionary effect was observed in the economy. In todays technological up gradation, it has been noticed that the energy conservation is a very important tool to get rid of this problem. It reduces the dependency on the oil imports thus minimizing the impact of the price hike in oil industries.

The fall in the terms of trade refers to the sharp transfer of wealth from the oil importing countries to the exporting one, the real income will be declined due to this price rise.

Through the aggregate demand model here, we represent the situation of the British economy with the light of impact of rise in the oil prices.

Adverse demand shock: a significant hike in oil price

The model is here being used to analyze what should be the key targets or economic policies to fight with the external shocks. The activity here has been designed to show the role of the aggregate demand in this kind of situation of the economy. The model used is a simplified one. Models are used to compare the reality with a standard perfect situation (POSSO, 2012).

It helps us to diagnose how far the real situation is from the ideal one. It gives the idea about the non-standard ceases also by changing the main variables. It can be checked by varying one or more than one variables, then what happens if the economy gets that kind of shock. It helps to predict the future situation and rectify the economy over time with the method of rational expectation (SHU, 2007).

As we go on the deep of the problem, the model becomes more complex, as the availability of information diminishes.

An increase in oil prices majorly affects the aggregate demand as the oil is such a product which is used in almost every industry. So hike in oil prices will cause increase in the price of the factor inputs which lie on the economy. So it will cause the aggregate demand schedule to shift rightward so that inflation increases than the initial situation.

It is obvious, because as we have discussed earlier that the oil price hike causes the deterioration of the purchasing power of the common people. And here fall in real national income refers to the same situation.

The contraction in the aggregate demand lowers the real income causing a lower economic growth faced by the economy. Now low economic growth causes lack of employment as the prospect of future recruitment is very disappointing in the industry (Zhang et al., 2014).

So in case of Britain what we notice in case of increase in oil price is the severe unemployment in the industrial economy, because of the dependency of the modern technology on the energy sector. The economic interpretation is very clear, as each industry is more or less dependent in the energy sector, so this external shock of significant oil price hike causes massive inflation resulting severe unemployment in every sector due to the fall in real national income.

Output or income

What we notice in the above diagram that the fall of oil price causes the aggregate demand curve to shift to rightward.

Real Income and wealth effect on aggregate demand

What we can see in the diagram, is that at the new equilibrium point, price level falls so inflation decreases. Another point is that the output level or the real income level increases than that of the initial situation. As real income is Y/P. As P falls, Y/P automatic increases in case of fixed Y. The economic interpretation is that the economic development is observed while the real income increases. It accelerates the pace of the economic growth for that particular oil importing nation. Now as the energy sector is solely dependent upon the availability of the crude oil, its volatility as the factor cost severely affect the economy. Now as the price of oil falls as in this case, it opens up several employment opportunities. So, we can say that this positive demand shock can reduce the unemployment of Britain as an oil importing nation.

Now the significance of this new equilibrium is that the real income level comes back to the initial position. So a natural level of unemployment is always maintained in the economy. But the price level does not go up to the initial position. So, we can interpret that, a positive demand shock can take care of inflation and unemployment in the short run but only the inflation in the long run.

References

Davis, G. (2003). Book Review - Oil and the Economy: Recent Developments in Historical Perspective, edited by James L. Smith. EJ, 24(4).

Debating Aggregate Demand and Aggregate Demand: Introduction. (2010). Review of Radical Political Economics, 42(3), pp.307-307.

Ioannides, Y. (2014). Neighborhoods to nations via social interactions. Economic Modelling.

Ito, K. (2010). The Impact of Oil Price Hike on the Belarusian Economy. Transit Stud Rev, 17(1), pp.211-216.

Lawn, P. (2006). Using the Fisherian concept of income to guide a nation's transition to a steady-state economy. Ecological Economics, 56(3), pp.440-453.

Nakano, T. (2004). Theorising economic nationalism*. Nations and Nationalism, 10(3), pp.211-229.

Oil Price Review. (2013). Oil and Energy Trends, 38(7), pp.10-12.

OIL PRICE REVIEW. (2010). Oil and Energy Trends, 35(10), pp.10-12.

Pandey, R. (n.d.). Macroeconomic Implications of Oil Price Hike. SSRN Journal.

POSSO, A. (2012). REMITTANCES AND AGGREGATE LABOR DEMAND: EVIDENCE FROM SIXTY-SIX DEVELOPING NATIONS. The Developing Economies, 50(1), pp.25-39.

SHU, J. (2007). Correlation between adenylosuccinate lyase (ADSL) gene polymor-phism and inosine monophosphate acid (IMP) content in domestic fowl and genetic relationship between red jungle fowl and domestic fowl. HEREDITAS, 29(03), p.343.

Zhang, G., Liu, P., Gao, X. and Liu, M. (2014). Companies’ Behavior of Carbon Emission Reduction at the Risk of Oil Price Volatility. Procedia Computer Science, 31, pp.291-298.