November 2007

What a daunting question! With oil prices increasing rapidly in the recent
past, it is hard not to wonder what has caused it and just what effect it might
have on the rest of the economy. Let me begin by discussing the evolution of
oil prices over time.

How have oil prices behaved in recent decades?

Figure 1 shows the history of the price of oil since the early 1950s. The price
shown is the monthly average spot price of a barrel of West Texas
intermediate crude oil, measured in U.S. dollars. The gray bars in this and all
the following figures represent recessions, as defined by the National Bureau
of Economic Research.

Figure 1. Spot Oil Price ($ Barrel)

As you can see from Figure 1, a long period of oil price stability was
interrupted in 1973. In fact, the 1970s show two distinct jumps in oil prices:
one was triggered by the Yom Kippur War in 1973, and one was prompted by
the Iranian Revolution of 1979. Since then, oil prices have regularly
displayed volatility relative to the ’50s and ’60s.

Figure 2 shows the “real” oil price, calculated by dividing the price of oil by
the GDP deflator. 1 This removes the effect of inflation and thus gives a more
accurate sense of what is happening to the price of the commodity itself. In
essence, the “real” measure allows you to compare oil prices over time in a
way that you can’t when inflation is also part of the change in price. You can
see that real oil prices have varied a lot over time, and large fluctuations tend
to be concentrated over somewhat short periods. You can also see that by the
spring of 2008, as this posting was prepared, the real price of oil has easily
exceeded that of the late 1970s.

Figure 2. Real Oil Price

Why are oil prices rising?

It is likely that both increases in demand and fears of supply disruptions have
exerted upward pressure on oil prices.2Global demand for oil has been
increasing, outpacing any gains in oil production and excess capacity. A large
reason is that developing nations, especially China and India, have been
growing rapidly. These economies have become increasingly industrialized
and urbanized, which has contributed to an increase in the world demand for
oil. In addition, in recent years fears of supply disruptions have been spurred
by turmoil in oil-producing countries such as Nigeria, Venezuela, Iraq, and
Iran (Brown 2006).

The breathtakingly sharp increase in the price of oil in the last half of 2007
and first half of 2008 has led many to argue that increased speculation in
commodity markets has played a role, and indeed there is evidence of
increased activity in these markets. However, whether speculation is playing
a role in high oil prices is open to debate (Krugman 2008). It is also useful to
remember that both the demand for and the supply of oil react sluggishly to
changes in prices in the short run, so very large changes in prices can be
required to restore equilibrium if demand should move even modestly out of
line with supply.

As far as the implications of higher oil prices, there are both microeconomic
and macroeconomic answers to that question. I will address both of these
aspects in turn.

How do high oil prices affect the economy on a “micro” level?

As a consumer, you may already understand the microeconomic implications

of higher oil prices. When observing higher oil prices, most of us are likely to
think about the price of gasoline as well, since gasoline purchases are
necessary for most households. When gasoline prices increase, a larger share
of households’ budgets is likely to be spent on it, which leaves less to spend
on other goods and services. The same goes for businesses whose goods must
be shipped from place to place or that use fuel as a major input (such as the
airline industry). Higher oil prices tend to make production more expensive
for businesses, just as they make it more expensive for households to do the
things they normally do.

It turns out that oil and gasoline prices are indeed very closely related. Figure
3 plots average monthly oil prices from 1990 through early 2008, using the
spot oil price for West Texas intermediate (right scale, thin blue line,
measured in dollars per barrel) and the U.S. retail gasoline price (left scale,
thick red line, measured in cents per gallon). The two series track each other
very closely over time: increases in oil prices are accompanied by increases
in gasoline prices. As shown in the graph, the correlation coefficient (denoted
“r”) for the two series is 0.98. Moreover, the monthly changes in oil prices
and gasoline prices (not shown) also are very highly and positively
correlated.
 Figure 3. U.S. Gasoline and Oil Prices

So, when oil prices spike, you can expect gasoline prices to spike as well, and
that affects the costs faced by the vast majority of households and businesses.