A shock is an unexpected or unpredictable event that affects an economy. In this note we look at some of the shocks that hit countries at different points in time and how macroeconomic policy can be used to act as a shock absorber for an economy.
Open economies and macroeconomic shocks
The UK is an open economy, one that is highly integrated within the global economy. From one perspective this increases the sensitivity of our economy to outside events for example a recession or slowdown in key export markets will inevitably have downside effects on demand, output and employment in the UK.
However the integration of the economy with other nations also provides opportunities to smooth our own economic cycle – depending on what is happening to cycles, exchange rates and policy changes elsewhere. Much rests on the flexibility of our economy to be able to absorb external economic shocks and then bounce back when the opportunity arises.
The table below provides a listing of some of the world’s major economies. Clicking on each country’s name will send you to a country profile, either at the Economist website or the BBC news web site. This will allow you to find out a little more about the economic structure and recent performance of each country.
Shocks to the system!
Like all economies, Britain is susceptible to exogenous shocks – i.e. unexpected economic events which originate independently from outside our own system and which may have the effect of driving the economy off course.
Exogenous shocks can be split into two main groups
Demand side shocks – these are shocks affecting the rate of growth of demand both in the UK and other countries
Supply-side shocks – these are shocks affecting costs and prices in different countries
Possible demand-side shocks might include:
A capital investment boom e.g. a construction boom or rapid growth of spending on ICT
A pre-election government spending spree (e.g. the government opting for a fiscal policy expansion before an election)
A sudden and significant rise or fall in the exchange rate – affecting net export demand and having follow-on effects on output, employment, incomes and profits of businesses linked to export industries
A change in the rate of economic growth in one or more of the countries of our major trade partners which affects the demand for our exports of goods and services
An unexpected cut or an unexpected rise in interest rates (i.e. a “monetary policy shock”)
Changes in aggregate demand brought about by a demand-side shock will then translate into changes in the short term rate of growth as measured by the annual change in real GDP. This can create disequilibrium in the economy which takes growth, prices and incomes away from their projected levels. The ripple effects of an external shock can take some time to work their way through the circular flow of income and spending.
The government and/or the central bank may decide to make “policy changes” in order to absorb the shock effects. For example their might tighten monetary policy if demand is expected to rise too quickly; or they might inject some liquidity /spending power into the economy if a negative demand shock raises the risk of a deflationary recession.
Cyclical fluctuations in the USA – the world’s largest economy
Supply-side shocks to the economy – oil prices
There are many possible supply-side shocks to the global economy. Some of them prove to have long-term beneficial effects, for example the emergence, adoption and take-up of a new production technology arising from invention and innovation that has the effect of reducing cost for producers and prices for consumers. Often it takes several years for the full impact of such supply-side shocks to become apparent and for their full significance to be recognised.
We will focus here on the effects of volatile prices in the global oil market and in particular, the dramatic rise in oil prices in recent years. The financial pages of the press have been full of commentaries on the possible impact of this inflationary oil price shock in the global economy. What follows below is a discussion of some of the macroeconomic effects of rising oil prices.
The macroeconomic implications of rising oil prices depend on several factors
- The extent to which rising oil prices are temporary (i.e. lasting only a few months before falling back) or regarded as more permanent (e.g. a period of 3-4 years of high prices). In general, the impact of higher oil prices will be larger the longer the price rise lasts. The possibility exists of “super-spikes” in oil prices, short but sharp movements in prices driven higher or lower by speculative buying and selling.
- Whether a country is a net importer or exporter of oil – Britain is still a net exporter of oil (though we import a lot too!) whereas Germany is a large importer of oil.
- The scale of oil dependency of an economy i.e. the ratio of oil used per unit of national output produced. Some countries have a reliance on high-energy using industries and are therefore more susceptible to changing commodity prices. Others have a much smaller manufacturing base and national output is dominated by industries that are less energy intensive
- The extent to which oil users (consumers) can switch their demand away from oil towards alternative energy substitutes. In the short term, demand is said to be inelastic (i.e. Ped<1).
- The macro-economic policy response to rising oil prices from central banks (e.g. changes in monetary policy) and the government (e.g. changes in fiscal policy)
- The effects of exchange rate changes arising from oil price movements e.g. the pound might rise against the US dollar which could absorb some of the effects of higher oil prices on the British economy.
- The extent to which the labour market is flexible (in particular the flexibility of real wages) and the ways in which businesses react to higher oil costs
How high can oil prices rise? What might be the economic implications of oil priced at over $100 per barrel?
Main disadvantages of higher oil prices for the UK economy
- A fall in aggregate supply and higher inflation: The main effect of rising oil prices in the short term is on aggregate supply. A higher price causes an inward shift in SRAS and puts upward pressure on the general price level. This is an example of an ‘exogenous inflationary shock’. Research carried out by the International Energy Agency suggests that if world oil prices were to remain 10% above a base forecast level for two years this would add 0.4% to the average rate of inflation for leading economies in each year. The effects on inflation can be increased if “wages follow prices” – because if inflation expectations rise, this can cause an increase in wage demands as people seek to protect their real incomes. Higher oil costs work their way through the supply chain. So manufacturers pass on higher costs to wholesalers who do the same to retailers. Consumers often end up paying the price for higher oil prices when they make their final purchase. Air fares rise and petrol prices increase – these are two most obvious symptoms of higher oil prices in the immediate term. Higher prices for consumers reduces their purchasing power in real (inflation adjusted) terms. But gradually higher oil prices filter their way through most parts of our economy.
- Slower economic growth: Higher oil prices act as a dampening effect on the rate of growth of real GDP. According to the IEA research mentioned above, a sustained $10 per barrel increase in oil prices from $25 to $35 would result in the OECD as a whole losing 0.4% of GDP in the first and second years of higher prices. This is because higher prices cut into people’s real incomes and their real purchasing power. And because companies are making less profit (because of higher costs) this can lead to a reduction in planned capital investment. Both consumption and investment are important components of aggregate demand. The result can be a slowdown in growth leading to actual GDP falling below potential – i.e. a negative output gap. And slower growth will hit jobs, not just in those industries that depend on oil but across the whole economy. Another effect of rising oil prices could be to erode business confidence. This too will have a negative effect on output and investment intentions. Similarly a reduction in company profits might have a negative effect on share prices, falling share valuations effectively increases the cost of capital for firms wanting to issue new shares to finance an expansion and a decline in equities would also hit consumer confidence. The actual effect of higher oil prices on world economic growth depends in part on what those countries that are accumulating huge trade surpluses as a result of being oil exporters, decide to do with these surpluses.
- A worsening of the terms of trade – the terms of trade measure the relative price of imports compared to the prices that exporters receive for selling their output overseas. An oil-price increase leads to a transfer of income from importing to exporting countries through a shift in the terms of trade – i.e. the terms of trade for oil importing countries gets worse because they are now having to pay more per barrel for their oil – and therefore having to export a greater volume of exports to pay for this. Conversely, higher oil prices improve the terms of trade for the leading oil-exporting countries. Their oil is worth much more on the global market, their potential export revenues are much higher as a result and this is will be an injection of income and demand into their circular flow.
- Impact on the balance of payments - the effects of higher oil prices on the balance of payments are somewhat different for the UK compared to most other Western European countries. The UK has large reserves of North Sea Oil and we have run surpluses in trade in oil for over twenty years as the next chart shows. Higher oil prices will increase the cost of out imports of crude, but the value of our exports of Brent crude also rise. The net effect is probably positive for the current account of the balance of payments. However exporters of non-oil products may suffer from the oil price shock. Since higher oil prices reduce real incomes of oil consumers around the world, firms suffer not only from a drop in demand in their home market but from overseas as well. So exports fall causing a reduction in aggregate demand and exacerbating the fall in GDP growth.
So how great is the current world oil price shock?
Oil Market Supply and Demand |
2000 |
2005 |
|
(in million barrels per day) |
Demand for Oil |
|
|
OECD |
47.9 |
49.7 |
of which: North America |
24.1 |
25.4 |
Europe |
15.1 |
15.6 |
Pacific |
8.7 |
8.6 |
Non-OECD |
28.7 |
34.0 |
Total |
76.6 |
83.7 |
Supply of Oil |
|
|
OECD |
21.9 |
20.3 |
OPEC total |
30.9 |
33.9 |
Former USSR |
7.9 |
11.6 |
Other non-OECD |
16.2 |
18.2 |
Total |
76.9 |
84.1 |
Trade in Oil |
|
|
OECD net imports |
26.2 |
29.6 |
Former USSR net exports |
4.3 |
7.8 |
Other non-OECD net exports |
21.9 |
21.7 |
Prices |
|
|
Brent crude oil import price |
|
|
($ per barrel) |
28.4 |
54.4 |
Source: International Energy Agency |
The recent rise in the real oil price has been not been as large as the surges seen in 1972-74 and 1978-80. Even after the recent rise, oil prices are still lower in real terms than they were in 1981 and the major developed countries are less dependent on oil now than at the time of the 1979-80 oil shock, reflecting both improved energy efficiency and the shift away from energy-intensive industries towards the service sectors.
Higher oil prices have supply and demand-side effects on the UK and the international economy – thus far the sharp rise in oil prices has not led to an acceleration in inflation and a high risk of a recession.
Oil prices and interest rates
Will higher oil prices lead to an increase in interest rates? In theory it might well be the case because higher crude oil prices will feed through to an increase in the general price level and may threaten to take consumer price inflation above the Government target of 2.0%. A tightening of monetary policy designed to dampen down the threat of cost-push inflation would then have negative effects on aggregate demand and GDP growth.
But a rise in interest rates is not automatic, because the Bank of England takes a full range of inflation indicators into account when making decisions on the direction of monetary policy. It does not have a specific target for oil prices – indeed the price of crude is only one part of a jigsaw of factors that they must consider when considering the likely path of inflation over the next two years.
The evidence for the UK over recent years is that the volatility in crude oil prices is no longer as important in influencing the rate of inflation as it was in the past. Our oil-energy ‘dependency ratio’ has declined and the flexibility of our labour and product markets has increased, which has the effect that pay is more flexible in response to changes in inflationary pressure (i.e. wages no longer automatically rise when inflation surges).
To add to this, many businesses have experienced a decline in their ability to pass on increases in their input costs when there are changes in raw material prices – this is partly due to the fierce competition in many industries arising from globalisation.
We should be wary of analysts who exaggerate the likely impact of the current oil price shock on the British macro-economy both in the short and the medium term. There are risks to the whole global economy from a period of much dearer oil, but the risk that higher oil prices will tip the global economy into a recession or slump are not as great as people often believe.
Suggestions for further reading on the oil price issue
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| Author: Geoff Riley, Eton College, September 2006 |
