Musings on the Macroeconomic Effects of Oil Price Increases
Varvares, Chris, Business Economics
In considering the macroeconomic effects of oil price increases, it is important to he mindful of whether changes come from the supply or demand side and whether they are accompanied by impacts on financial markets. Also, it is important to know whether a change is likely to be temporary or permanent and whether it can be offset by policy responses. Finally, the short-run effects of oil price changes are likely to be different from the long-run effects. This paper explores these questions and their ramifications for macroeconomic growth.
Keywords: oil prices, GDP, economic growth, financial uncertainty
There are several issues, somewhat related, that should be considered when thinking about the macroeconomic impact of oil price increases. First, it is important to distinguish whether the price change is due primarily to changes in supply or changes in demand. Second, we need to recognize that oil price swings are often accompanied by, or even caused by, geopolitical considerations that can roil financial markets, whose impacts on growth can be significant. Failure to separately account for these financial impacts could result in incorrectly ascribing GDP growth effects to oil price changes. Third, the near-term effects may also depend on whether the oil price change is expected to be temporary or permanent. Fourth, what is the scope for a policy response? Fifth, how long-lasting will the effects be on the level or growth of GDP?
1. Supply or Demand
We think about a supply-induced positive shock to oil prices as arising out of an actual or announced curtailment of physical supply or from an increase in the risk premium that is built into forward prices, in turn caused by an increase in uncertainty about future oil supply. The effect of the rise in oil prices is negative for all oil-consuming nations. In the first instance, domestic consumption of an unchanged amount of energy sends more domestic income abroad, leaving less to be spent on other domestic production, so aggregate demand relevant for driving GDP falls. In addition, oil price shocks may increase risk aversion of the sort we find typical of any initial slowing in economic activity. There can be a partial offset if "petrodollars" are recycled. Exports might rise, directly offsetting some of the weaker demand, or domestic asset prices might be supported by the inflow of foreign investment. Lesser declines in the prices of equities, via a wealth effect, would reduce some of the weakness in consumer spending originally caused by the oil price rise. These positive feedback effects often pale by comparison to the drag exerted by the original rise in energy prices.
A demand-induced rise in oil prices, given no change in actual or perceived supply of oil, acts as negative feedback in restraining an otherwise robustly expanding economy. The partial macroeconomic effects of the oil price rise would be expected to be similar to the supply-induced price increases but the context in which they occur, and hence outcomes, potentially would be quite different. A demand-induced rise would likely be seen alongside a global economy characterized by fairly strong growth. Of course, initial conditions matter. Strong growth beginning from a low level of GDP and still quite ample excess oil capacity would have little effect, until the rise in oil demand began to reduce excess capacity and begin to put more substantial upward pressure on prices. At some point, the demand-induced rise in prices could overshoot, perhaps aided by some speculative impulses, and the rise in oil prices could be sufficient to take a meaningful bite out of the growth of demand.
The oil price increase seen from late 2011 through March 2012 arguably has been mostly supply-side driven--related to loss of Libyan light crude production and concerns over the potential loss of Iranian oil exports--and not a result of strong global demand.
2. It is Hardly Ever "Just about Oil"
The circumstances surrounding the actual or expected decline in supply can matter a lot. …