Monday 16 June 2008

How Oil Prices Affect Consumer Spending

The price of oil has doubled over the last 12 months reaching almost $140 per barrel last week. How this boom in oil prices may affect global economy and consumer spending?

To answer this question correctly one should try to understand the origin of the current oil shock. Indeed, the present surge in oil prices has been mostly driven by increases in demand from rapidly growing developing countries like China, India, and Brazil. Also, supply problems in Russia, Nigeria and Venezuela have accelerated the rise in energy prices even further. Since the elasticity of supply and demand for oil is almost inexistent, the reduction of crude supply connected with the moderate increase in demand may have caused the surge in the price of barrels. For example, in the past, over periods of less than five years, oil consumption in the OECD dropped by only 2-9% when the price doubled, according to the research published by Gary Becker, an economist at the University of Chicago. Likewise, oil production in countries outside OPEC grew by only 4% every time the price doubled. Yet, over longer periods, consumption dropped by 60% and supply rose by 35%.

In addition, eve though the share of oil in Gross Domestic Product is relatively small, oil price shocks could affect the economy through aggregate demand, particularly consumption. People start spending less on other goods since they need to pay more for energy and gasoline. Moreover, customers may also purchase fewer products that are complementary with oil, like cars. Higher oil prices also raise the cost of production for firms, resulting in lower investment spending. Finally, one the biggest impacts of high energy prices, many times forgotten by economists, is the psychological impact. High oil prices encourage precautionary saving by the consumer and the greater economic uncertainty normally means fewer jobs.