The Economic Impact of Rising Oil Prices

Table of Contents

1 Introduction 4

2 Historical Overview of Oil prices 5

3 Dependence on Oil and Impacts of High Oil prices 7

Determining the Dependence of a Country 8

Dependence on oil-imports 8

Substitution 10

Costs Compared to Income Level 10

Impacts of High Oil prices on the Economy 10

Decline in Aggregate Demand 11

Production Costs 11

Inflation and Unemployment 12

Investment 12

4 How to Minimise the Negative Effects of High Oil prices 13

Monetary Policy 14

Implementing Monetary Policy 15

How Federal Banks Use Their Tools 16

Government Incentives and Environmental Policies 18

Course of Action Diagram 20

5 Conclusion 22

6 Bibliography 23

Table of Figures

Figure 1 - Oil Price Development 5

Figure 2 - Comparative Analysis of Oil Dependency in 2004 8

Figure 3 - Instruments, Targets and Objectives of Federal Banks 16

Figure 4 - Policy Responses to a Rise in Oil Price 18

1 Introduction

The rising price of oil is a burning theme nowadays that societies have to deal with. The impact of rising oil prices creates economic, as well as social problems. High oil prices can lead to substantial output reductions, decreasing nominal wages, increasing competitiveness in oil dependable businesses and unemployment. Getting a precise assessment of how much a country is affected and what counter measures can be implemented is of interest for both governments and individuals.

Making predictions into the future is not what this paper is about. It also does not analyse in depth specific factors influencing the oil price. The strength of this paper, however, is that it tries to generalise - on a non-mathematical approach - how economies are influenced by different factors and which appropriate and corresponding counter measures can be taken.

In the first part the paper gives a short historical overview of how the oil price has developed in the last decades and points out the most important events that have influenced the oil price. In a second part it will be explored to which degree a country depends on oil and the factors influencing high oil consumption. An assessment is made of the different impacts the oil price has on nations mainly belonging to the Organisation for Economic Co-operation and Development (OECD) and the economic consequences for developing countries. Furthermore, the paper deals with typical monetary and fiscal policies that are implemented by most industrialised nations to reduce the shock of oil price hikes. The paper closes with a tentative conclusion that summarises the most important findings.

2 Historical Overview of Oil prices

Figure

1950 - 1972 The nominal price of oil remained stable at about US-$ 2 per barrel and in terms of the real price it even declined from about US-$ 14 to US-$ 9 per barrel.

1973 - 1974 In Oct. 1973 the Yom Kippur War started with an attack on Israel by Syria and Egypt. The Israelis received strong support form the USA and other western countries. As a result several Arab oil-exporting nations imposed an embargo on the countries supporting Israel.

1974 - 1978 The oil price remained at a relatively stable level, in terms of real price it even slightly declined.

1979 - 1980 The combination of the Iranian Revolution and the Iraq / Iran War caused another major increase of the oil price.

1981 - 1994 In this period the price came down to a relatively normal level with two exceptions; 1987 an OPEC-price-accord and 1990 the Iraqi invasion and the following Gulf War affected the oil price again and led to a temporary increase.

1994 - 1997 The slight rise of the oil price was mainly caused by the growing demand for oil, especially in the Asian region.

1998 The combination of lower consumption (due to the economic crisis in Asia) and the higher oil production of the OPEC caused prices to fall in 1998.

1999 - 2002 The oil price recovered since the OPEC adapted its production and the global demand started growing again.

2003 The war on Iraq and the unrests in Venezuela caused another increase of the oil price.

2004 - 2005 The price increase was mainly due to the unexpectedly rapid growth of consumption (plus 2.9 million barrels per day, of which China almost 1 million barrels per day). Another reason for the increase in late 2005 can be given by the strong hurricane season in the US.

2006 Uncertainty of political development in Iran and the ongoing growth of global demand for oil are made responsible for the latest increases of the oil price (Williams, 1-7).

3 Dependence on Oil and Impacts of High Oil prices

The currently high price of crude oil amounting to almost US-$ 70 per barrel (May 2006) definitely has a significant impact on the global economy. But the high oil price does not influence every economy by the same degree. Industrialised nations for instance experience a less severe impact than developing countries do. This is because developing countries are generally more dependent on imported oil and because they are not able to use energy as efficiently as industrialised nations. The cause for their lower efficiency and therefore higher dependence is often a lack of availability of advanced and expensive technologies such as efficient fuel powered vehicles, and expensive oil dependent energy production. On average, developing countries need more than twice the amount of oil to produce the same economic output as industrialised countries do. The impacts described in the following part are valid for both ¬- industrialised and developing countries - but for the latter the impacts on the economy are usually much