However, one of the most recent reasons for a surge in oil prices is ‘market speculation’ i.e. purchasers buying now believing in a future rise in the price on world markets. Due to oil stocks being low and the panic about future supplies given the political turbulence in the Middle East, speculators are buying up any available stocks and in doing so driving up the price even higher. The major oil consumers are very keen to secure their supply and are buying forward contracts, hoping that by the time the contracts are fulfilled a significant profit will have been made.
b) Evaluate the likely economic consequences for the UK economy of a higher price of oil.
Inflating oil prices can be highly consequential for both the demand side and the supply side of an economy. Clearly however, the main effect of rising oil prices in the short run is on aggregate supply. Recently rising oil prices has been an example of an ‘exogenous economic shock’ to the UK economy in that we have got used to relatively low oil prices and now have to consider what the effects of it might be. Higher oil prices reduce the amount the economy can produce without igniting inflation. As illustrated in the below diagram, higher prices of crude oil, one of the most heavily traded commodities in the world, will cause an inward shift of the short run aggregate supply curve from SRAS1 to SRAS2, hence a rise in the general price level from P1 to P2. This is known as cost push inflation.
If wages follow prices than the effect of this inflationary pressure on the economy is made considerably graver. The trend is that as price levels rise, the workers feel more and more hard done by, demanding higher rewards for their efforts. This in turn increases the firms’ costs even more and a wage-price spiral commences. If inflation is expected to rise, people want to protect their real wages, and in doing so their standard of living. But, because of the increase in production costs due to the recent surge in input costs, often the market cannot afford to pay higher wages. As a result of this higher inflation and the risk of a wage-price spiral, the monetary policy will be forced to raise interest rates.
However, higher oil costs tend to work their way through the supply chain, in the end eventually resulting in the consumer paying the extra cost in some cases. In the immediate term, however it is the air fares and the cost of filling up one’s tank that are the obvious symptoms.
These higher prices results in one’s disposable income (ones income after tax and benefits) becoming progressively less due to the highly inelastic demand, hence one spends less on other goods and services. Plus depending on whom carries the burden of the extra cost, the consumer or the producer, businesses may have lower profit margins and therefore cut any planned capital investment. Furthermore, businesses may wish to cut output, suspecting low consumer confidence, and this in turn results in them reducing their workforce. Unemployment is forecasted to peak at 3.8% on the claimant count measure in the first half of 2006.
Considering that consumer spending alone accounts for just under two thirds of aggregate demand (C+I+G+X-M), bearing in mind the UK’s present marginal propensity to consume, deflationary pressure could result. A forecast from GBS Group Economics says that for these reasons, consumption growth in 2005 will be less that 1.0, which is as low as it was in the ‘90s recession. Lack of Investment from industry and the manufacturing sector will exaggerate this effect. The graph below, signifying slower economic growth, shows a fall in aggregate demand from AD1 to AD2, resulting in a negative output gap which portrays a slowdown in growth leading to actual GDP falling below the potential for the economy.
Not only will this negative output gap start to erode business confidence affecting investment plans and output levels but also QP – Q1 represents unemployment in the economy, not just in the oil related industries but nationally. Plus, declining share prices, resulting in falling equities may have a knock on effect on the confidence of the consumers.
Due to the lower inflationary pressures caused by fall in disposable income and lower profitability resulting in lower economic growth, the monetary policy would wish to cut interest rates. This is clearly a problem if there is inflation and a risk of wages following the prices, and it becomes their choice as what to do and when!
The terms of trade of the UK economy will also worsen. The increase in price means that we spend more on imports (withdrawals from the circular flow of income), meaning that we have to export more to pay for this (injection). This is a very good thing for the leading oil producers in the world because through receiving more for their exports, they receive increased injections into their economy.
However, the UK has large reserves of North Sea Oil, and as shown in the following diagram the Net Balance of Trade in Oil has been positive for almost 25 years. Although the cost of imports will rise, the value of exports will also rise resulting hopefully in a positive impact on the current Balance of Payments. Countries that solely import oil products will see the rising oil prices as a negative exogenous economic shock and will have to boost exports to counter-balance the possible balance of payments deficit.
On the other hand, one does have to consider the stability of the global economy; will oil prices continue to rise? Will China’s economy continue to grow at such a rapid rate? Will OPEC maintain its pivotal influence on the world economy?
Unfortunately I simply do not have the time to put any more hours into this ew, otherwise I would of course evaluate these questions!
Sir, I would be very grateful if we could talk about UCAS and universities in the next few days. I am no longer going for geography at oxford but now hoping to read economics, hence I need to write a new personal statement asap! Sorry for not going into to much evaluation towards the end.