Impact Of Oil Prices On Inflation Economics Essay
The purpose of this term paper is used to determine the relationship between oil prices, Inflation, exchange rate, money supply and unemployment. Secondary data is used for this study and the sources of data are mentioned in this paper.
The simple OLS method has been used to determine the relationship between oil process, inflation, exchange rate and money supply.
Using annually data from 1980 to 2010 and following results were found during my research study. There exist the positive relationship between inflation and oil prices.
To illustrate the economy conditions of country, we use basic macroeconomics indicator. Inflation is one of the basic macroeconomic indicator. In the economy, this rate is used for the measurement of stability of price. Inflation comes from domestic purposes and from external factors as well in open economy countries. External factors become a source of increasing in world commodity prices.
The population of Pakistan is increasing very rapidly and Pakistan has become the six largest country.
The price of oil and inflation are often seen as being connected in a cause and effect relationship. Oil prices increases continuously and inflation follows the same direction. It just happens because oil is a major input in economy, it is used in critical activities such as fueling transportation and heating homes and if input cost increases, so should the cost of end a plastic company will then pass on same or all this cost to consumer, which raises prices and inflation, also increases.
A salient feature of recent oil price hikes has been reduced impact that they seem to have had on general price levels worldwide when compared with the previous oil shocks. This situation results in the increase of oil price which results in the decline of output. Decline in inflation results due to decline in exchange rate. It becomes difficult for policy makers due to change in oil prices and it also creates difficulty for making decision in business. It has a adverse effect on the economy.
Enhancement in oil prices effect the consumer price index (CPI) directly by increasing its energy cost component, which includes price of CPI such as gas and electricity. As crude oil is converted into gasoline and fuel, so their prices follow the prices of oil closely. Energy cost increases due to increase in price oils because they are directly related to each other. The extent to which oil prices translates into higher overall inflation through high energy cost depends on their persistence. If they continue increase, they may lead to huge change in overall price level, that is to increase in overall inflation rate.
The high degree of dependence of oil producing countries and any irregularities in price and supply has adverse effect for an economy that import crude oil to cater to its often fragile industry.
Since 1970’s rapid change in prices are of concern in almost all the countries. In Pakistan, like all the developing countries, the domestic price level started rising from the mid 1970’s. In early 1980’s, the exchange rate started depreciating continuously. It leads to suggest a correlation between the two variables due to continuous devaluation of currency and inflation in 1980’s. In 1970’s the oil prices rose to vey high and 1980’s has not been far from the minds of public or of monetary policymakers. Rising oil prices were followed by the double digit inflation in developed countries in those early episodes. Central bank says that they are affirmative not to repeat this, amassing that they are in favor to held integrity with the public by securing low inflation and achieving stable and well anchored inflation expectations. The key measures policymakers often focus on oils core inflation this may seem surprising since core inflation exclude energy prices is that they are typically quite volatile for example, after increasing rapidly and hitting a record high $145/barrel in July 2008 and then again fall back to $100/barrel in September. Temporary oil prices increase do not intend to pass through the prices of non energy foods and services when the central bank is creditable that is when inflation expectations are well anchored and therefore will not result in higher overall inflation rate.
Core inflation focuses the public attention on this measure is an indicator of what future inflation is going to be like. Those who set the prices and wages can find the core inflation may help in influencing the long run inflation expectations price of oil and exchange rate changes affect inflationary pressure from increase in the prices of oil.
As oil prices stabilize, as they have recent months, the corresponding pressure of inflation will disappear. As a result, both basic and overall measures of inflation may decrease with the overall inflation rate likely decrease towards the lower rate of basic inflation.
For the world inflation, 2010-11 is the most eventful year. The inflation poses serious threats to macroeconomics stability around the world. The worrying thing is that the recent spike in inflation is coming more from food inflation is likely for poverty situation. By ADB study, a 10% rise in flood inflation is llikely to deteriorate peverty situation by 2.7% points. Either increase in aggregate demand or a decrease in aggregate supply, inflation results. These two sources effect price level of an economy. Demand pull inflation arises from many factors like money supply, government expenditures, exports or gross domestic products etc. We can define cost push inflation as increase in general price level resulting from increase in cost of production. The main sources of cost push inflation may be decrease in aggregate supply that may be due to cost of production, increasing wages, higher imports, rising taxes, budget deficit or fiscal deficit.
OBJECTIVES OF STUDY
The basic purpose of this study is to determine the impact of oil prices on the inflation in Pakistan. The purpose of this research is to determine which factors are affecting that results an increase oil prices in Pakistan and how they can be controlled and what step should take to government to control the increase prices and remove the inflation and i hope this research will produce or increase my knowledge.
Inflation as a key indicator provides important insight on the state of the economy and the sound macroeconomic policies that govern it. A stable inflation not only gives a nurturing environment for economic growth, but also uplifts the poor and fixed income citizens who are the most vulnerable in society. The Government needs to be cautious about inflation and thus has taken various steps to release demand pressures on the one hand and enhance supplies of essential commodities on the other. To ease demand pressures, the State Bank of Pakistan (SBP) has continuously tightened the monetary policy over the last three years and more so in the current fiscal year, while to enhance supplies, the Government has relaxed its import regime. The CPI is the main measure of price changes at the retail level. It indicates the cost of purchasing a representative fixed basket of goods and services consumed by private households. In Pakistan, the CPI covers the retail prices of 374 items in 35 major cities and reflects roughly the changes in the cost of living of urban areas.
The monetary policy in Pakistan aims at stabilizing the domestic and external value of the currency to stabilize economic growth.
The high degree of dependence on oil producing countries and any irregularities in prices and supplies has a pervasive effect for an economy that imports crude oil to cater to its often fragile industry. Following the sharp surge in oil prices since 2003, developing countries that rely heavily on oil imports, are now faced with an increased threat to macroeconomic instabilities, with Pakistan as no exception. This brief note provides an overview of international oil price trends witnessed since 2002. Observations are also made on how domestic furnace and high speed diesel oil price trends move in consonance with the international oil prices. The need to focus on furnace oil and high speed diesel oil prices trends arises from the fact that of the total production by oil refineries of major components of crude oil, diesel constitutes the highest share of 31% with furnace oil comprising the second largest share of 29.4% in Pakistan (2006 to 07 estimates).
DETERMINANTS OF INFLATION
The demand pressure is one of the major determinant of the inflation. It is the combination of expansionary monetary and fiscal policy. The increased domestic demand due to remittances from abroad outpaced the domestic production creating a positive output gap which results an increased in prices and as a result inflation occurs.
Secondly the growing gap between domestic demand and domestic production was filled by a sharp rise in net imports. The imports increases more as compared to exports. So as aresult trade deficit occurs. A rising trade deficit results an increase in high prices in future. So the growing gap is one of the indicator if inflation.
Third, fiscal policy has remained expansionary in the last few years. Expansionary fiscal policy fuels domestic demand and puts pressure on the current account deficit. In other words, it widens the investment-saving gap, which has to be financed externally. Moreover, financing of fiscal deficit through money creation adds to inflationary pressures. On the other hand, government borrowing from the SBP also increased, which again can have serious consequences on the general price level.
Fourth, the expansionary monetary policy through high growth in money supply and loose credit policy was also believed to be contributing to high inflation. Khan and Axel (2006), using monthly data from January 1998 to June 2005, conclude that the lagged growth of private sector credit and lagged growth of money supply (M2) are two significant causes of inflation in Pakistan in recent years.
EXPANSION OF CREDIT
Although expansion of credit is usual in expanding economies, the credit growth should not be allowed to reach unsustainable limits. The International Monetary Fund [IMF (2004)], through an extensive survey of developing countries, suggests that excessive credit growth in developing countries can have adverse effects on real variables.
RISING IMPORT PRICES
Rising import prices were also considered as an important factor in creating inflation. The exchange rate, if depreciating, in this scenario can also put upward pressure on price levels. Similarly, some people blamed indirect taxes for being the main cause of inflation. The wheat support price has also been identified as an important determinant of inflation in Pakistan by Khan and Qasim (1996) and Hasan et al (1995).
IMPACT ON INFLATION
Higher oil prices directly lead to increase in food prices. As a result there was a substantial increase in head line inflation. The recent need to import food items like wheat, sugar etc and depreciation Pak rupees further led to an increase in food prices. Due to an increase in global oil price and import bill of food group, headline inflation is constantly going upwards. The impact of inflation would have been worse, had the government not offered subsidies in oil products and food commodities. The fig shows the inflation experienced in food prices since 2002-2003 in major groups.
Similarly to other developed countries, Pakistan is facing too much inflationary impact of rising food and oil prices which is due to demand pressure. Soaring oil prices with increased food prices have a negative impact on growth and increase the cost of inputs. Facing from such situation the low income households find it very difficult to protect themselves against inflation especially those living in urban areas.