fossilfuelopolis

Prospecting the academic grounds on global energies patterns

The transmission channel of oil price shocks

After the occurrence of the two oil shocks (see history), many scholars have tried to estimate the macroeconomic effects of a rise in oil prices on oil importers economies.

Let’s begin with the microeconomic effects [the effects at individual (people, firms,…) levels]. According to Karim Pakravan (Oil supply disruptions in the 1980s) The effects on the firm are:

  • First, A rise in price should induce substitution of others fuels for oil
  • Second, we could observe substitution of other factors of production (capital-labor) for energy.

For firms, on the short run, it was argued, the first substitution could hardly take place.
And the second supposed possibility of substitution between capital and energy, which would mean those two factors are substitutes rather than complements.
The emerging consensus at that time was that energy and capital were mostly complements meaning a reduction in energy  availability could not be compensated by an increase in capital use, thus leaving output reduction as the only solution. As output decreases and costs go up (for many industries and services) employment and therefore consumption will decline, starting a multiplier  effect that will further reduce employment, production, and income.

On the long run, it was predicted in the 80s that considerable efforts on developing energy efficiency and independence from oil should be observe following the oil shocks making Western economies less dependent on oil. For reasons to be determined such developments have not occured. Our economies still rely heavily on fossil fuels- and if gas has been substituted for oil, its price being essentially indexed on the oil price, the effects of an oil price increase today should not be neglected as compared to the ones in the 70s.

What’s about the effects of oil price increase on the two Asian giants (China and India)? If we have observed  a rise in China’s oil consumption in the 2000s; Oil is not as used in China than in it is in Western economies. The importance of oil in Chinese production needs to be determined but we already know that China electricity consumption has and still relies heavily on coal (75%)) .

According to Karim Pakravan’s study introduced above, one of the main transmission from oil price increase is through a general increase in prices. The question is thus how much the general price index follows the rise in the price of oil? It particular did we observe a general increase in prices (financial assets and goods)  in the year 2006-2007 when the price of oil was dramatically increasing?

If we did, was the rise in prices (for both goods and oil- or energy products) due to another triggering factor (financial speculation)?

Mechanism

For the reminder, the aggregate demand tends to be a downward slopping curve for the following reason:
An increase in the general price level causes the real money supply to decrease, which in turn cause interest rates to rise and therefore generates a contraction of economic activity. (A decrease in the general price index would by the inverse mechanism causes an expansion). Second, a rise in the general price index decreases real wealth, thus causing consumption to decrease.
Finally, a rise in the general price level causes the price of domestic goods relative to the price of imports to rise, thus increasing the demand for imports.
GNP= C + I + X-M
Thinking of imported oil as an input in the production process. The rise in the price of foreign oil will cause the aggregate supply curve to shift upward. The effects on aggregate demand are less clear-cut; assuming inelasticity of demand for energy (at least in the short run), a rise in the price of imported oil will cause total energy expenditure to increase, thus causing total expenditure
to decline.
Could we expect some recycling of the windfall profits of the oil exporters in the form of an increased demand for exports of goods from oil-exporting nations and/or higher investments (buying financial assets) in the Western economies?
A Benassy Queré and V Mignon observed in a paper that the major parts of oil exporters revenues were re-invested in the US.
(Oil being exchanged in dollars tended to advantage the US).
Have we observe a shift in oil exporters investment in the late 90s or after 9/11? Could we observe higher investment of oil exporters countries (Middle East) toward the Asian geants? (thus challenging the dominant pattern of investment in the US)
What would be the effects of the current politics of the US of decresing their dependency on the Middle East oil and relying more on closer neighbors such as Venezuela and Canada or their recent transformation of energy mix toward the new use of schiste oil?
(see this recent post)oil_price_increase_mecanism

Comparative Statics
In the above picture, in the short term following the rise in oil price we should observe a shift of the demand curve downward and a shift in the supply curve upward. The new equilibrium is at a higher price level and lower output.
Dohner (“Energy prices, Economic Activity and Inflation: A survey of Issues and Results”) have estimated for the period 1973-1976 an elasticity of substitution between energy and non-energy inputs of 0.2-0.6.
Given the rise of relative energy prices of 57% over this period, it would imply an average increase in cost (energy cost per unit of output) of 20%.

Mitigating effects
A mitigating factor has been observed in the late 70s. OPEC nations increased their imports of goods and services from the industrialized countries by an average rate of 16.8% per year between 1974 and 1979. This massive increase in imports and direct investments compensated the wealth transfer which previously occurred. (from the oil importers to the exporters)

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