The Crude Art of Policy Making

Lessons: The Crude Art of Policy Making All over the world, the price of crude oil experiences wide price swings in times of shortage or oversupply just like other commodities. The crude oil cycle may extend over several years responding to changes in demand and supply. In this paper, we intend to discuss the dynamics and impact in the economy, and how the central banks respond to a rise in oil price. To be able to understand the dynamics of adjustment of oil price, we use the economic diagram of aggregate demand and supply given by D1 and S1 respectively in the left hand graph, where the points they intersect signify that the economy is in equilibrium. In the graph, Q1 is the output at the natural level of output and implies the price, P1. Based on the graph, the shift on aggregate supply curve to the left, to S2 is caused by the firm who imports crude Graph1. The impact of higher oil prices. oil. If the price of importing crude oil is high, then the firm’s production costs will also increase. As a result, it reduces profit so they supply fewer goods and services. This can also relate according to Blanchard, using the equation: P = Pe (1+?) F(1- u,z) where, u = unemployment rate ? = mark up of the price over nominal wage Pe = expected price level In this equation, given the Pe, the increase in the price of oil shows an increase in the mark up, ?. The increase in the mark up will lead the firms to increase their prices, leading to an increase in the price level, P, at any level of output, Q. Then, the aggregate supply curve shifts up or move to the left. In addition, the aggregate demand curve also moves left, to D2. The increase in the price of oil leads the firms to increase their price which decrease the demand and output. As a result, the consumers would be resulted in lower rates of consumption due to increase in the price level. Thus, economy suffers both a negative supply shock and negative demand shock. Over time, output decreases further and the price level increase further. Now we know the impact of the increase of price of oil in the economy. Second we want to know is how the central bank responds in this issue. According to the article, higher oil prices are neither inflationary nor deflationary in themselves. It depends upon how the monetary policy reacts. Based on the right-hand graph, it shows how policy responded after the 1973-74 oil price shock. This will attempt to prevent output falling. For example, based on the article, America’s Federal funds rate was cut from 11% in mid 1974 to less than 6% in 1975, resulting in sharply negative real interest rates. In effect, this shifts the demand curve to the right, to D3, with same output at Q1. But still, the price tends to increase to P3. To hold the inflation down, central banks must increase interest rates. On the left hand graph, this implies a further leftward shift in the demand curve and shows a larger decrease of output. Take note an increase in interest rates does not necessary imply a tightening of policy of inflation which caused by higher oil prices. According to the article, central banks need to raise interest rates to simply keep real interest rates stable. To be able to increase interest rates, there should be a sign of a rise in the core of inflation, excluding the energy prices. In Europe, the increase in inflation tends to spill over into wages compare in America because of less flexible labour markets. So the European Central Bank (ECB) will be more cautious when the oil prices increase. In addition, central banks must know the recurring position of the economy to know if they need to increase interest rates. If the economy is slack, the bigger the risk that increase in crude oil will quickly affect the wages and that firms will be able to pass on higher costs. In contrast, when economy is weak and the oil price decrease then it tends to risks of deflation, the central bank will cut the rates.