“The Crude Art of Policymaking”, printed in the Economist on June 10, 2004. The article asks how central banks should respond to a rise in oil prices. First, the author points out an increase in the average rate of inflation according to various CPIs, attributing this to the price of crude oil, which was 25% higher than the previous year. This is illustrated with a leftward shift of both the aggregate supply and demand curves in the graph. The aggregate supply curve shifts since a higher oil price increases the costs of inputs to produce goods and services, so firms supply less. Higher oil prices also means there is a contraction on the income and spending consumers have available, which also shifts the aggregate demand curve to the left. This causes a negative shock on both aggregate supply and aggregate demand- output decreases and while inflation can rise or fall, it is more associated with increased prices. It is then mentioned that the monetary policy of a central bank has a larger effect on inflation with increases in the price for oil. In the article’s example, the Federal Reserve responded to the OPEC 1973-1974 crisis by using stimulating monetary and fiscal policies, cutting the federal funds rate from 11% to 6%. If interest rates are low, the cost of borrowing money is low and therefore people spend more, speeding up the economy. The goal was to maintain output quantity by pulling up demand but prices also increased as a result. However, as the author points out, inflationary pressures caused by higher oil prices are not necessarily curbed by raising interest rates. It depends on the state of the economy at the time of the price increase. Generally, the less reserve capacity there is in an economy (or “slack” as the author calls it), the greater the risk of inflation spilling into wages and firms passing on the costs. For example, if economic growth has been high, there is a low interest rate in place, so borrowing to pay for increases in energy costs become attractive. Some economists argue higher oil prices have a deflationary effect and calls for cutting interest rates. This might have been proposed during slow economic growth. If economic growth has been low, there is a high interest rate in place and since the cost of borrowing money is high, people spend less. If goods and services have few substitutes (in the short run) as with oil, then there will be a smaller effect on the supply demanded should the price rise. And because borrowing is unfavorable, consumers will make adjustments to other demanded supplies to accommodate the increased price. This decreases the demand for other goods and services and those prices will not increase as fast. The correct response is to cut rates.
Posted on: Sun, 28 Jul 2013 17:54:08 +0000
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