Rising Oil

Prices and Inflation

What is Inflation?
Inflation is defined as a sustained increase in the general level of prices for goods and services.
It is measured as an annual percentage increase. As inflation rises, every dollar you own buys a
smaller percentage of a good or service.

Causes of Inflation:
-Demand pull inflation

If the economy is at or close to full employment, then an increase in Aggregate demand (AD
contains four components i.e. Consumption, Investment, Government spending and net
exports) leads to an increase in the price level. As firms reach full capacity, they respond by
increasing prices which leads to inflation.

AD can increase due to an increase in any of its components C+I+G+X-M

-Cost push inflation

If there is an increase in the costs of firms, then firms will pass this on to consumers. There will
be a shift to the left in the AS.

Cost push inflation can be caused by many factors:

1. Rising wages

If trades unions can present a common front then they can bargain for higher wages. Rising
wages are a key cause of cost push inflation because wages are the most significant cost for
many firms. (Higher wages may also contribute to rising demand)

2. Import prices

If there is a devaluation then import prices will become more expensive leading to an increase
in inflation. A devaluation means the currency is worth less, therefore we have to pay more to
buy the same imported goods.

3. Raw material prices

The best example is the price of oil, if the oil price increase by 20% then this will have a
significant impact on most goods in the economy and this will lead to cost push inflation.

4. Higher taxes

If the government put up taxes, such as VAT and Excise duty, this will lead to higher prices, and
therefore CPI will increase.

-Exchange rates
When the exchange rate of the Pakistani currency becomes less valuable relative to foreign
currency, this makes foreign commodities and goods more expensive to Pakistans consumers
while simultaneously making Pakistans goods, services, and exports cheaper to consumers
overseas.

Good side of Inflation:

Economists generally argue that some inflation is a good thing. A healthy rate of inflation is
considered to be approximately 2-3% per year. The goal is for inflation (which is measured by
the Consumer Price Index, or CPI) to outpace the growth of the underlying economy (measured
by Gross Domestic Product, or GDP) by a small amount per year.

Costs of Inflation:

Creditors lose and debtors gain if the lender does not anticipate inflation correctly. For those
who borrow, this is similar to getting an interest-free loan.
Uncertainty about what will happen next makes corporations and consumers less likely to
spend. This hurts economic output in the long run.
People living off a fixed-income, such as retirees, see a decline in their purchasing power and,
consequently, their standard of living.
The entire economy must absorb pricing costs (menu costs) as price lists, labels, menus and
more have to be updated.
If the inflation rate is greater than that of other countries, domestic products become less
competitive.

First Research Report

The first research paper is written by OBrien and Weymes and revolves around Irish economy
which is highly dependent on oil. It tells us how an increase in oil price affects the Irish economy
and leads to inflation. According to OBrien and Weymes the price impact of oil price changes
can be categorized as first- or second-round effects: first-round effects only give rise to a one-
off increase in the price level and are no long lasting. First round effects can be further broken
down into direct effects and indirect effects: Direct effects: Are concerned with the impact on
energy items contained in the index of consumer prices such as petrol and diesel prices. Note
that higher oil prices tend to be followed by higher gas prices, albeit with a significant lag, and
the impact of higher gas prices is sometimes also considered (and have been included here);
Indirect effects: Are concerned with the impact on consumer prices through production costs.
Higher oil prices result in increase in the cost of production of goods particularly for energy
concentrated processes in certain area. Higher oil prices may also have a significant impact on
the costs of transport services, especially for air fares which have a large oil input. Finally,
higher oil prices are gradually passed through to the prices of consumer goods more generally
through higher distribution costs.
The authors then defined Second-round effects as effects concerned with central banks. When
second round effects are present, higher oil prices not only increase the price level but also,
lead to more tenacious effects on inflation: Higher consumer prices arising from first-round
effects, although temporary, may raise inflationary expectations and push the consumer prices
up. Second-round effects may affect wage bargaining process. Employees may ask for higher
nominal wages to compensate for higher consumer prices decreasing their purchasing power.
Thus, firms, may pass on the higher labor costs to consumers to maintain profit margins. Higher
consumer prices may lead to demands for higher nominal wages, possibly beginning an
inflationary cycle.
Per the authors the extent of second-round effects in the economy will depend to an extent on
the prevailing macroeconomic conditions and on structural factors. A greater level of
competition in product markets and labor market flexibility can help to contain inflationary
pressures, as an appropriate wage reaction, where the impact of the oil price increase on real
incomes is accepted, will minimize the risk of an inflationary cycle. With a reliable monetary
policy aimed at maintaining price stability over the medium-term, the reduction in real incomes
is more likely to be accepted and inflation expectations are less likely to be affected by a
temporary increase in inflation. Oil value changes can influence purchaser costs frequently
through complex channels that develop after some time, which makes the undertaking of
evaluating the effect of oil costs changes very testing. One conceivable way to deal with
evaluating the immediate, aberrant and second round impacts of oil value changes
employments customary macroeconomic models. There are some solid restrictions to show
based examinations of the effect of oil value changes counting troubles in representing supply
side impacts, how to take into account basic changes.
Finally, it states that oil prices are already high by historical standards although the
international recovery is not yet robust and there is significant upside risk that oil prices will re-
emerge as a prominent driver of inflation when the recovery in developed economies gathers
further momentum. This likelihood is heightened by the downscaling of investment during the
crisis and the consequent tightening in energy supply. Measures to reduce oil dependency
more generally can help to make the Irish economy more robust to international energy
commodity price fluctuations while at the same time help address concerns relating to the
environment impact of fossil fuel consumption and the security of energy supply.

Second Research Report

The second research paper is written by Jamali, Shah, Soomro, Shafiq, and M. Shaikh and
investigates the relationship between changes in crude oil prices in Pakistan and Macro-
economy. It tells us how an economy like Pakistan which is completely different from Ireland,
the subject of our first research paper, and America, is affected by an increase in oil prices.
According to the second research paper by Jamali, Shah, Soomro, Shafiq, and M. Shaikh much
research has been conducted to understand the true relationship between oil prices and
various macro-economic variables, including inflation. Earlier work (by Jamali, Shah, Soomro,
Shafiq, & M. Shaikh, 2011) achieved to conclude that oil price movement lead to a decline in
long term interest rate, and oil price movement for both players involved. The study took the
following five macroeconomic variables into consideration: real gross domestic product (RGDP),
real effective exchange rate, money supply, short term interest rate, and long term interest
rate. The VAR model concludes that the factors which are affected marginally are money supply
and short term interest rate. The linear regression results stress on the fact that the effect on
variables in mostly seen in the first 3 quarters, by the 5th quarter the effect is minimized. A
permanent oil price shock has a major impact on the world economy. In Pakistan since the
transportation cost increases, therefore it shifts up prices of many products and services which
maybe directly or indirectly attached to oil. It is not only the oil-importing countries that have
to suffer, in fact the oil exporting countries have to face low demand in the consequent months
as the purchasing power goes down, lowering the GDP of the affected players. It used the linear
vector auto regression model to estimate a relationship between crude oil price movements
and macroeconomic variables in Pakistan and world economies.

NEWSPAPER ARTICLE
The article, which is taken from the Washington post and is written by Ylan Q. Mui, talks about
rising oil prices and how it affected the US economy. It states that an 8.1% increase in gasoline
prices in US led to an increase in the cost of production of goods leading to an increase in the
prices of consumer goods and leading to inflation. The federal reserve raised the interest rates
in June and central bank increased its benchmark rate to speed up the recovery process. The
article discusses how the US economy dealt with the situation, mainly by stabilizing oil prices
which reduced the effects and stabilized the economy. Having a strong economy helped US in
the recovery process and keep the prices stable and fostering maximum employment but Fed
officials still expect inflation to pick up once the effects of stronger dollar and low oil prices
dissipate.

ANALYSIS
The first research paper showed how a country like Ireland is affected by an increase in oil price
change while the second research paper examined about how Pakistani economy, which is very
different from Ireland, is affected thus providing us a better idea and giving us a better view of
the situation. In both situations, the result remained the same, which was that an increase in oil
price would increase the production cost of goods decreasing the purchase power of the
employee who would then demand more money from the employer and as a result a never-
ending cycle of inflation. The article also supported this theory discussing the situation of
America showing an increase in oil prices leading to an increase in the prices of consumer goods
which further led to inflation. It stated that an 8.1% increase in gasoline price in US led to an
increase in costs of goods at the fastest pace in last three years, food prices increased by 0.2%
and housing and medical services rose by 0.3%. This proves that an increase in oil price does
lead to inflation no matter the circumstances. The result of an increase in oil price is the same
but how a country tackles it is a different issue. This point is also discussed in the research
paper, which states that a country with a greater level of competition in product market,
flexible labor market, an appropriate wage reaction and with a reliable monetary policy will be
less effected by inflation. The article supports this fact as well showing how United states
economy tackled an increase in oil prices and how the effect of inflation was reduced because
America had a competitive market and flexible labor market which helped its economy to
stabilize by controlling unemployment and oil prices. This approach helped US to counter the
effects of inflation as suggested by the paper.
So, in conclusion the two research papers and the article which discuss three very different
economies show us that practical and theoretical economics do match in this matter giving us a
broader image of three very different situations and proves the hypothesis better.