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Impact of Oil Prices on U.S. Economy

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Although the U.S. economy reacted to the shock of dramatically higher oil prices during the 1970s with a rapidly rising rate of inflation, there is relatively little evidence that the current rise in oil prices will produce a similar inflationary impact. In theory, significantly higher oil prices will have an inflationary impact on the economy of an industrialized nation because a very high proportion of output is linked to oil. In addition, there are only imperfect substitutes for oil for industrialized nations, with other hydrocarbon products such as coal or natural gas not readily substituted for oil. Impact of Oil Prices on U.S. EconomyThe actual use of oil the U.S., however, has decreased since the 1970s, reducing the macroeconomic impact of rapidly rising oil prices. As a result, the inflationary impact of rising oil prices is likely to be offset by reductions in prices in other areas of the economy, with an increase in oil prices only moderately increasing inflation. This is demonstrated by the relatively low inflationary impact that the rise in oil prices had in 2000.

After the inflationary impact of the oil shock that occurred in the 1970s, there was considerable research into the relationship between oil prices and inflation. The conclusion arrived at by economists was that there was a symmetrical relationship between oil prices and inflation in the U.S. and other industrialized nations, with inflation increasing in proportion to the increase in oil prices. This model predicted that a decrease in oil prices in the short to medium run would result in an increase in output. During the 1980s, however, such an increase in output did not accompany lower oil prices, suggesting that the relationship between oil prices and the economies of industrialized nations had changed.

There exists a school of thought that the world’s total recoverable supply of oil is half depleted and that, at that  some not very distant point in the future, production will decline, this decline to be accompanied by big increases in the price of the commodity. It is to be noted that the various components of the international energy industry and such authoritative sources as the International Energy Agency and the U.S. Geological Survey do not agree with these projections, but two things about them are important.

  1. First, if the projections do prove to be accurate, then we had better begin to do everything we can do to lessen our need for petroleum.
  2. Second, and perhaps more importantly, even if the projections are not accurate, we should recognize that the current situation respecting energy prices is already something which is causing harm in the world.

Today’s oil prices are what might be termed “inconvenient” for the rich countries of the world. They are much more than an inconvenience for the poorer countries of the world. Wirth et al note, “for most developing countries, the necessity of obtaining oil for the transportation sector saps foreign exchange and sends scarce dollars abroad, away from critical social needs such as education and health”. Because $65/barrel oil prices have not yet sent the United States economy into recession, or caused large scale inflation, does not mean that there is no problem. The existing level of oil prices exacerbates the already dire economic problems of developing nations.

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