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Global economy

Examine the likely impact of a significant rise in the world oil price on the global economy (60 marks)  During 2004 oil prices have risen substantially and steadily. This has created much uncertainty within the economy as fears of what had happened during earlier periods of soaring oil prices are very much in sight. A rise is oil prices is an example of a supply shock. This means that there will be a transfer of income from oil consumers to oil producers, and as the propensity to spend of those who lose income is generally larger than the propensity to spend of those who gain income, therefore there will be some fall in demand.

This fall in demand means that households would cut down their expenditure on goods such as petrol by using public transport as the petrol prices would have risen. This rise in oil prices increases the cost of goods, household expenditure and costs of production, and these high prices would act as a deterrent to the buoyant consumer spending the economy is now enjoying because people would not have such high disposable incomes.

However, on an international level, the transfer is from oil importing countries to oil exporters, and oil

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exporters tend to expand demand only gradually. In addition, a reduction in demand can also occur within producing countries that allow higher oil prices to feed through to consumers, as oil producers tend to have a lower propensity to consume than oil consumers. There will also be a rise in the cost of production of goods and services in the economy, given the increase in the relative price of energy inputs, putting pressure on profit margins. As the oil intensity of production in advanced countries has fallen over the past three decades, the supply side impact for a given increase in oil prices can be expected to be less than in past episodes.

This negative supply shock may lead to inflation. However, the extent to which this supply shock causes inflation depends entirely upon the elasticity of the supply curve at the point where AD cuts AS. Therefore if the section is more inelastic, inflation will increase much more drastically as the economy is close to full capacity. Also, the extent to which prices rise depends upon the elasticity of demand for the goods in question. Therefore, if the goods are highly price elastic, the increased burden of the cost of production would not be passed onto consumers.

In developing countries, however, where the oil intensity of production has declined less, the impact may be closer to that in the earlier period. There will be an impact on the price level and on inflation. Its magnitude will depend on the degree of monetary tightening and the extent to which consumers seek to offset the decline in their real incomes through higher wage increases, and producers seek to restore profit margins. These responses can create a wage/price spiral, as was the case, for example, during the oil shocks in the 1970s.

There will be both direct and indirect impact on financial markets. Actual as well as anticipated changes in economic activity, corporate earnings, inflation, and monetary policy following the oil price increases will affect equity and bond valuations, and currency exchange rates. Finally, depending on expected duration of price increases, the change in relative prices creates incentives for suppliers of energy to increase production (to the extent that there is scope for doing so) and investment, and for oil consumers to economize.

However, the impact is somewhat larger for industrial countries than for developing countries as a group, particularly as regards domestic demand, largely due to terms-of-trade effects (as many developing countries are net oil exporters). However, the significant diversity across developing countries, in particular the mixture of oil exporters and importers, means that the impact on individual developing countries is often large. However, within these assumptions there are flaws.

Firstly, one does not know the impact of higher oil prices on the other energy products, such as gas, which is a particularly important source of energy in the transition countries. Secondly, the impact of the rise in oil prices may be amplified if they exacerbate existing macroeconomic imbalances or lead to inappropriate policy responses, particularly in oil importing countries. Finally, depending on the culture within each country changes in consumer demand will differ, therefore it is difficult to make clear assumptions and predictions as to what may happen on an international scale.

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