The Effects of High Gas Prices on the Economy

The Effects of High Gas Prices on the Economy

According to the World Economic Outlook, continuously rising prices of petroleum prices have various effects on the world economy. The magnitude of effect varies from case to case, say for climate change and destruction of the environment. Increasing gas prices affect the economies of industrial and developing countries. Moreover, many other countries relying to the traders of oil or the suppliers of gas are so much affected by its prices. Fares are fluctuating and people suffer for not having a constant long time price for their petroleum.

According to Mussa (2000), among the first effects of increasing oil prices is that the bulk of the income will shift from the oil consumers to the oil producers. Since the tendency of the energy consumers to spend is greater than the tendency of energy producers to spend, the quantity oil demanded would fall. Likewise, demand reduction can also occur in the oil-producing countries that consent increased higher oil prices to reach the level of those who will consume them, as producers have a lower tendency to consume.

Figure 1. World oil market prices, 1972-2000 (Mussa, 2000)

Consequently, production and shipping costs of products and services in the economy will inevitably rise. Unbearable pressure might inadvertently be applied on pressure margins and this is not easily relieved due to the increase in relative prices of energy inputs, the most important components of which generally are petroleum products, by-products, and derivatives. In comparison, though both experiences severe economical impacts, developing countries are more affected by oil increase than advanced countries.

The extent of monetary reduction, the degree to which the consumers seek to counterbalance the deterioration of their actual purchasing power through increase in daily wage, and the measures taken by producers to re-establish their margin of profit – these factors dictate the magnitude by which oil price increase will have an impact on the price level and on inflation.

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.

Global economy would be highly affected by trade shock due to increase in oil and petroleum products via supply and demand effects as well as through inflation and higher wage claims. In effect, worldwide bank effective interest rates are likely to increase to make up for the impact of pressures due to inflation, as well as the effects of the oil price increase on different activities. Additional means would be provided by the impact on asset prices and financial markets.

Effects of increasing petroleum products are most likely to be felt in the greatest magnitude in Asia, where there exists relatively fewer oil producers. Present circumstances give way to unwelcome breaks in economic activities. Margins of surpluses and deficits are most likely to hit critical levels, thus pushing local economies to their limits.

Several lessons were learned by financial institutions from past oil increases throughout history. One important lesson learned was that monetary policy should not accommodate second-round impacts of oil price shocks. It is of utmost concern to act immediately to anticipate second-round effects of consequent pressures due to inflation. Costs of succeeding disinflations are amplified by incorporation into inflationary expectations. Thus, monetary authorities are discouraged to accommodate an oil price shock.

Alteration of existing fiscal policies is likewise discouraged if purposes are founded on easing the pains resulting from oil price increases. Negative effects of fiscal policy adjustments are basically the same with those of monetary accommodation as earlier discussed. It is important that an in depth analysis of the fiscal policy be done and presented to the people.

Other related markets can reduce costs of an oil price hike on any activity. For example, labor markets can ease the pressure exerted, especially on the general consumers via high degree of real wage flexibility. Making relative stability of employment is one of the most significant responses to an oil price shock. This was employed by the Japanese government in 1979, and the effects were desirable. It should be likewise noted that non-market solutions, such as quantitative restrictions are not the necessary steps.

Indeed, economies worldwide are highly affected by oil prices. It is very apparent in the reports and news that are presented to the people from time to time. Government levels down to the ordinary consumers feel the impact of such adjustments. The appropriate strategy will depend upon the tax structure of the country concerned. Particularly for countries that have regulated prices, a full pass through of the oil price increase would generally be appropriate, if consistent with the overall macroeconomic and fiscal situation of the country.

References

Mussa, M. (2000, December 8). imf.org. Retrieved August 10, 2008, from International Monetary Fund Reports: http://www.imf.org/external/pubs/ft/oil/2000/oilrep.pdf