Explain and illustrate the effect of this shock, and the courses of action the Government and the Bank of England are, in your opinion, likely to take as a consequence. Discuss the implications for business of both the initial shock and the following Government and Bank actions. You should assume that the Government of the day has committed itself to full employment, “prudent” public spending, and no major tax increases. The Bank has an inflation target of 2. 5% pa.
A long run equilibrium is one in which the aggregate markets – financial, product and resource, are in equilibrium simultaneously This is made possible by flexible wages and prices and is represented by the intersection of the AD (aggregate demand) curve and the LRAS (long-run aggregate supply) curve. It is important to establish whether the economy is in a long run equilibrium, in order to maintain a ceteris paribus while assessing the speculative increase in the price of oil.
By assuming that all other factors are constant, it makes it possible to begin to solve the issues arising through the price rise through a mix of individual and/or grouped solutions. Oil is a commodity that is deemed demand inelastic. Like many other neccessity’ goods, a change in price will result in a disproportionately lower change in the demand for the good. (See Fig 1) People and firms would be unable to avoid consuming the same amount of oil in the short term even if there was an increase in its price, due to the fact that there are no available direct substitutes.
Manufacturing firms who burn oil for power cannot simply shut off their generators, public buses that run on petrol and diesel products will not discontinue their services and citizens who heat their homes and water with oil will need to continue doing just this. If oil was easily substituted in the short term, or if it had a more elastic demand, then the effects on the national economy would not be so great. People would simply stop buying the commodity and over time, the price would drop back to where the market dictates the equilibrium point of supply and demand.
However, because we have asserted that oil would be bought at the new price, albeit marginally less than at the previous one, then the effect on the national economy will be great. Primarily any action taken by the bank or the government will be enacted in order to quell any inflationary reaction that will take place. Inflation that arises as a result of increased costs along the production chain is known as cost-push inflation.
As seen in Fig 2, cost-push inflation occurs with a leftward shift of the aggregate supply curve, which is independent of any movements in aggregate demand. Because the demand for oil is highly price inelastic, producers know that they can pass on the increased costs of the oil directly to the consumer, without the need to absorb them at the firm level. They may also cut back on production slightly in the short term in order to avoid a current surplus, however, as the demand for oil would not be expected to drop significantly, this approach would be a cautionary one.
A rise of the price of oil by 15 percent would stimulate a single shift in the AS curve, which is known as a supply shock – whereby there is a temporary inflation taking place while the price rise is passed through the economy. A stabilisation of prices will then take place, and thus inflation will subside. A blanket increase in the price of oil is hence known as import-price-push inflation, where the import prices of a commodity increase independently of the level of aggregate demand’ In general however, good-price inflation has tended to be lower than service-price inflation.
This is as a result of the fact that there is a higher rate of growth of productivity in goods markets relative to services markets. Goods are traded internationally to a greater extent than services and capital equipment tends to replace labour to a greater degree in the production of goods compared with services’. However, although a 15% increase in oil prices is not considered to be great, especially considering the volatile fluctuations that have occurred either side of the campaigns in the Middle East, when the rise is believed to be permanent, then the effects will carry more weight.
The OECD tends to refer to a basic rubric when considering the effects of an increase in the price of oil and states that a $10 increase, if sustained for a year, would increase the inflation rate in rich economies by about half a percentage point and knock about a quarter-point off growth’ Taking the current price of oil to be at around $35 a barrel, then the projected increase in price will take the price to $39. 25, representing a $4. 25 raise.
If we are to speculatively ratio this with the stated inflationary effect, then the U. K, along with the other M. D. C’s, would experience inflation at just under a quarter percent, with growth slowing at just under an eighth of a point. Considering that the government attempts to keep inflation at between 2. 25 and 3. 5%, then a speculative increase of under a quarter percent would not be considered material. However, considering the cyclical and integrated nature of the national economy, it is not possible for one to assume that the economy would be able to accommodate this additional inflation at ever point of the cycle.
There will also be other effects of the price rise, such as increased unemployment within the sectors that are oil-reliant and an increase in credits on the balance of payments. The problem of falling employment is an issue that directly conflicts with their objective of full employment and the government will see a double-decrease in revenue’ through a fall in income tax and an increase in welfare payments, as well as increased criminal activity which is statistically linked to the unemployed.
Lower unemployment will also result in a decrease in aggregate demand as there is a lower level of total disposal income and thus a decrease in GDP can be observed. (Fig 3) This problem can be most effectively solved either through retraining of a subsidy on the governments’ part to the firms whose human resources are affected most. The balance of payments will be affected as the U. K is a major exporter of oil, through the reserves in the North Sea and the increase in the price of oil means that the net worth of the imports would rise, known as an increase in credit.
Credits on the balance of payments are generally viewed as being beneficial to the economy, as they free more foreign capital for the purchase of imports and the generation of interest on the foreign-initiated debt. However, the primary aim of Bank of England and the government would be to return the economy to a stat of long run equilibrium. In order to cull the inflationary effects and the possible decrease in aggregate demand, it would need to use both fiscal and monetary policies effectively.
Fiscal policy involves the utilisation of taxes and government spending in order to stimulate demand. A discretionary fiscal policy would have to be adopted, as the government wishes to avoid direct heavy taxation and keep to a model of prudent’ public spending. The best method of doing this would be to increase indirect taxes, which involves setting a tax premium on each barrel of oil. As seen in Fig 4, when this indirect tax is applied, it has the effect of moving the supply curve upwards, and runs parallel with the previous supply curve as the tax is the same at all prices.
The increase in taxes would not only encourage deflation through demand, but the taxes raised could be reinvested back into either the oil industry or 3rd generation’ power companies, which are aiming to create new methods of power through research into harnessing the power contained in inert gases. Both reinvestment in established energy sectors and spending on research and development into emerging ones would help to reduce the cost of oil in the long term.
The government could also drop income tax slightly in order to raise the national level of disposable income, which would have fallen through an increase in unemployment. However, this would only be done if the government felt that that keeping growth levels up is worth risking further inflationary pressure. Monetary Policies are designed to control the level of money circulating in the economy and are monitored and tailored to the current state of the economy by the independent Bank Of England.
Bearing in mind that a raise in oil prices brings with it inflation and a potential fall in economic growth, we can see that it is difficult to raise the level of national spending to where both spending and inflation are in line with expectations. As Seen in Fig 5, if the bank of England increases the money supply, interest rates will fall, with the resultant shift in quantity representing the increase in money supplied and demanded.
This fall in interest rates will encourage spending, private sector investment, borrow, hence raising aggregate demand in line with the governments aim of prudent’ growth. Unemployment will rise as the demand is satisfied, UK products will appear cheaper to those abroad, and thus there will be a balancing effect on the balance of payments. In conclusion, I feel that as any increase in the price of oil will only be inflationary in the short term, then using monetary policy to boost AD would prove too risky, as it will create inflationary pressure itself.
Indirect taxing is probably the most efficient way of handling the problem, although the average consumer will end up taking a bigger hi than a 15% rise in prices. However, in light of the dangers associated with fossil fuels, I feel that over the long term creating new, environmentally friendly energy sources should be a major objective of the government, and by weakening the grip of the oil industries through a forced reduction in demand they will be creating new energy sector opportunities.