macroeconomic consequences for the UK of the recent increase in the price of oil, The

Teaching Business & Economics, Summer 2005 by Gausden, Robert

Throughout 2004, there occurred a substantial rise in the price of oil. During the final quarter the price of Brent crude oil exceeded $50 per barrel for the first time. The marked increase stimulated economic commentators into contemplating the likely consequences for the UK economy. The consensus to emerge was that the effects on the UK economy would be relatively modest. While output growth would be adversely affected, the economy would not enter into a recession, in contrast to the experience in earlier decades. Also, it was believed that the UK economy would be more robust to the increase in the price of oil than either other European economies or the USA economy. This article presents reasons for the optimistic view of the ability of the UK economy to withstand a significant increase in the price of oil. However, it concludes by issuing the warning that, on account of demand as well as supply factors contributing to the recent price rise, the oil price may remain at a relatively high level for the foreseeable future.

At the time of writing this article, in February 2005, the price of Brent crude oil was equal to $44.63. Although the price had come down from a peak of over fifty dollars, recorded in October 2004, this still represented a 40% increase over its average value during the first quarter of 2004. Furthermore, this amounted to a rise of more than two-thirds over the average price of Brent crude oil during the first four years of the new millennium.

HISTORICAL AND THEORETICAL CAUSES FOR CONCERN

A reference to both history and economic theory encourages a pessimistic view of the consequences for the economy of a significant increase in the price of oil. In a seminal paper published in the 1983 edition of the Journal of Political Economy, James Hamilton drew attention to the fact that all but one of the post-World War II recessions in the USA had been preceded by an increase in the price of oil.

Diagram 1 indicates that a similar correspondence has applied to the UK. The graph shows, over the period 1973-2003, the annual percentage change in the price of Dubai crude oil (PCHPOIL) and also in a volume measure of UK GDP (PCHGDP). Over the period concerned, it is apparent that the UK has suffered three major recessions. GDP declined by 1.35% in 1974, 2.06% in 1980, and 1.36% in 1991. Prior to each of these falls in output, there occurred a substantial rise in the price of oil. More specifically, with respect to the intervals 1972-1974, 1978-1980 and 1988-1990, the oil price increased by 448%, 174% and 54% respectively.

Within macroeconomic theory, the standard framework for analysing the consequences of a change in the price of oil is a model of aggregate demand (AD) and aggregate supply (AS). The AD-AS model is depicted in Diagram 2. The AD schedule indicates the quantity of output of the domestic country that is desired by households, firms, government and foreign countries at different price levels. The schedule takes the form of a downward-sloping line for the reason that the higher is the price level, the higher will be the rate of interest, and the lower will be private investment. Also, an increase in the price level will reduce international competitiveness and result in a reduction in the domestic country's net exports.

The AS schedule indicates the quantity of output that the domestic country produces at different price levels. The schedule has been drawn as an upward-sloping straight line, and applies to the short run. Within the Macroeconomics literature, different arguments have been provided for the existence of a positive relationship between the supply of output and the price level. One (New Keynesian) explanation that has been offered is that, in the short run, wages are fixed in nominal terms, on account of contracts that have been agreed to by employers and workers. Consequently, an increase in the price level results in a fall in the real wage, which renders it profitable for firms to increase their employment (and output).

Using the framework of an AD-AS diagram, an increase in the price of oil has the effect of shifting the AS schedule upwards. The outcome is the same, irrespective of whether mark-up or competitive pricing is assumed. Upon observing Diagram 3, it is apparent that the upward shift of the AS schedule (to AS') produces simultaneously a higher price level (P^sub 2^) and a lower level of output (Y^sub 2^). Consequently, an oil price rise results in both price inflation and a negative growth of output, twin evils that have become known collectively as stagflation.

Should the government of the domestic country seek to restore output to its original level then there are two policy options available. One approach is to do nothing. In this case, the reliance is upon the relatively low level of output and high rate of unemployment to exert downward pressure on prices and nominal wages, such that, diagrammatically, the AS schedule will return to its original position. The alternative strategy consists of actively intervening, expanding demand through, for example, increasing government expenditure or lowering taxation. Diagrammatically, the AD schedule shifts to the right. As can be seen from Diagram 4, though, the cost involved is an even higher price level (P^sub 3^).