How does the price of oil cause both inflation and unemployment to develop?
here is the actual question..
How may (will) the increase in the price of oil affect aggregate supply and cause both inflation and unemployment (stagflation) to develop in the U.S. economy?
December 23rd, 2009 at 7:30 am
The question is poorly constructed. Blaming the price of oil for the inflationary pressures that cause people to pull back spending completely misses the root cause of the problem.
Oil is a commodity denominated in dollars. When the US dollar is debased, as was the case after 1971 when Nixon ended the fatally flawed Bretton Woods system, the price of oil (and all other commodities and metals denominated in dollars) rises. The fed inflated throughout the 1970s to wart of a recession. As prices rose, the government implemented price controls to stop the price of gas from rising. When companies were no longer able to pass along the true costs of the gasoline in their pumps, supply of gasoline dried up. Fuel companies could not afford the continually rising price of the oil needed to make gas.
Beyond that, in the 1970s, OPEC was able to reduce the world’s oil supply and force the world gas price to increase. In part, this action was due to the unjustified demand resulting from run-away inflation of the US dollar. Under normal market conditions, such an effort would disrupt sectors of the economy that are tied to oil, but only in the short run. Rising prices would encourage consumers to direct consumption toward those uses that are most important to them (this is called marginal thinking) and they would encourage producers to find more oil. The recession that the Fed spent the 1970s trying to fight off would have stopped the crisis before it got started.
But such normal conditions didn’t prevail in the 1970s because of government intervention in the oil markets. While gas prices rose during that time, they weren’t allowed to rise to the levels dictated by supply and demand conditions.
Due to price controls, the market’s response to OPEC’s attempts to maintain a successful cartel was muted, causing the cartel to be successful much longer than it otherwise would have been. At the time, this policy was seen as being humane, meant to help the average consumer. In fact, it delayed the adjustment process and prolonged the suffering of all consumers of oil. The oil crisis came to a quick end when price controls were finally removed in 1981.
Unfortunately, failure to confront the recession and allow bad investments to reallocate made the recession in the early 1980s all the more severe as interventions were eased and the market was permitted to do its work. Rather than allowing the minimally inflated values to unwind in the early 1970s, the market had to resolve the disconnect between the actual value of investments, assets, and employment and the inflated value of each which had been leveraged beyond manageability as a result of fed induced credit expansion.
December 23rd, 2009 at 7:30 am
This happened during the 1970’s
Oil is an input with few subsitiutes, when the price of oil went up the price of production went up, as a firm couldn’t reduce their use of oil or subsitute for it, as a result they cut cost by laying of workers, but the rise in the price of oil was greater than the saving they got by laying of staff. As a result the price of goods had to increase to allow the frim to continue to sell the good and make profit, resulting in less o the good being traded
MICHELLE B: you said the labour force was any one over 15 years old, you’re wrong a labour force is made up of people who are seeking work or are in work, as a result this doesn’t include university students, house wives, people on disability benefit, retired people etc.
This is basic stuff you’ll learn within 2 weeks of starting any decent Macroecomoics course
To model this to show , draw a graph with units of oil on the y axis and labour on the x, now draw a budget line, now draw an isoquant at a tangent to the budget line, now the price of oil rises but you can’t subsitute away from oil to labour, in order to remain on the same Isoquant you have to cut back on labour and increase oil, until the budget line is tagent to the isoquant again, this results in less labour and a higher price to produce that quanity
December 23rd, 2009 at 7:30 am
An increase in oil price has nothing to do with productivity. It’s then the cause of the cost-push inflation. People will buy less and cause the investment and the economy to stagnate.Most of the oils consumered in the US are imported. It will also cause the dollar to depreciate. That’s too the cause of inflation and stagnation.
December 23rd, 2009 at 7:30 am
Rising oil increases cost of getting product to market. As supply drops, prices rise. Say it is cotton. It costs more to get it across the country. Profits drop. Growers cut back & lay-off people. That in turn affects another industry, clothing mfgrs. They have to pay more, charge more, people stop buying & more lay-offs
Cotton may not be the best example, but hope you see what I mean.