High Energy Cost and Inflation

“According to the labor department report, the 2008 July inflation rate hit the highest of 5.6 percent since 1991” (Maura, 2008), which was fueled by high prices of energy. The high cost of energy caused a 0.8 percent monthly increase in the consumer price index, which was twice the level predicted by the analyst. Analysts pointed out that the July figures were base on data collected at the beginning of the month.

The high cost of energy was attributed to the increasing world oil and gas prices. The month of July saw the price of oil per barrel hit $ 140, the highest figure since 1975. (See the graph in appendix) The US is the world’s highest oil consumer and since it is a net importer of oil any international increase in oil prices has a negative impact on the US economy. We use gasoline and electricity to run machines in our industries, transportation of the finished products requires energy. Hence as the cost of energy rises the effect is great and in most cases, the burden resulting from the high cost of energy is felt by the consumer. Producers will always ensure themselves against losses due to the high cost of energy by increasing consumer prices. As the prices of energy come down, the prices of gasoline will fall translating to lower prices of consumer goods.

Since production cost is based on the cost of energy, high energy prices will increase the marginal cost of production. If the cost of production is high and production is at maximum, producers can not maintain profits margin by selling their output at initial prices. Therefore, producers will transfer the increased costs to consumers through increased prices of the goods. According to analysts consume expenditure accounts for two-thirds of the nominal gross national product (GDP). A high inflation rate generally reduces the purchasing power of currency; if prices are high the monetary unit buys fewer goods.

Consumer expenditure is an element of the expenditure approach used in estimating the national income. Increased inflation causes a surge in real consumer spending as consumers cut spending on luxurious goods, lowering the gross national product. Consumers’ real income is reduced when the inflation rate is high unless adjusted for inflation and hence consumers will reduce their spending. As general consumer spending declines, low numbers of GDP are experienced which in the end slows down economic growth. As a result of the increased cost of living, the government may be forced to make some transfer payments such as social security and pension benefit as an allowance for the cost o living. Such allowances increase government spending which may call for increased tax translating to more inflation.

The high inflation rate not only affects consumers alone but, it has a negative impact on the economy. The inflation rate increases future uncertainty which discourages saving and gross investment and it also reduces the return on investments because; inflation weakens the purchasing power of a currency. With high inflation rates lenders offering inflexible interest rates on loans lose the purchasing power of earned interest and the borrowers gain. The money they receive at the end of the lending period will have lost its purchasing power as the rate of inflation sours up. As a move to ensure investors against inflation interest rates are adjusted to accommodate inflation. Adjustments on interest rates mean that interest rates are raised which increases the cost of borrowing capital and in turn increases private investment. This is harmful to the economy because if the levels of savings and investments are low the gross domestic product is low which results to slow economic growth.

Due to the high inflation rate, “workers’ weekly real wages declined by 0.8 percent in July, compared to the same period the previous year according to the labor department.” (Maura, 2008) Workers with fixed wage rates are much affected by inflation rates. As prices of goods and services sour up the purchasing power of the wage declines, hence the need to adjust wages for inflation. If workers union demand for an adjustment in gross wage to incorporate inflation rates the gross wages increases. As result, the demand for labor goes down meaning more labor force will remain unemployed. Again increased gross wage rate increases the cost of production and as result employers might lay off more workers increasing the rate of employment. According to the law of demand for labor, high labor prices (wage rate) employers will not need more workers causing unemployment. According to the US government reports, due to the July high inflation rates, the number of workers who lost jobs averaged 450,000 every week

Conclusion

Nearly all the world’s economies whether large or small have experienced high consumer prices resulting from the high cost of energy. Oil is widely used by many industries around the world to run machines and automobiles, hence any changes to the prices of oil have a negative or positive impact on production and hence consumer prices. In moth of July 2008, the world crude price reached high of US $ 140 and as a result of such high prices in a short time period, most prices of basic commodities in many countries shot up. The result was a high level of inflation across economies that caused a recession in the most venerable economies. Consumer spending rates declined, economic growth slowed down, many jobs were lost due to the increased cost of production, and financial institutions lost heavily from the money they had lent.

Glossary

  1. The inflation rate is a periodic percentage change in price indices such as consumer price index, cost-of-living index, producer price index, and commodity price index.
  2. The consumer price index is an average measure of goods and services purchased by households in a country.
  3. Nominal gross national product is the total money value of the goods and services produced in an economy at a given period of time
  4. Consumer expenditure refers to the total amount of money spent by consumers on goods and services over a period of time.
  5. Economic growth is the increase in the number of goods and services produced in a country at a specific period of time and is usually measured as an annual percentage change in gross domestic product.
  6. The Law of demand of labor states that as the price of labor (wage rate) increases above the equilibrium market price less labor will be demanded.
  7. Gross investment is the total amount of domestic investment without taking into account the effects of depreciation.
  8. Rate of unemployment is a term that refers to the percentage of workers in the labor force who are not employed.
  9. Return on investment is a measure used to evaluate the viability of a number of different investments or to determine the efficiency of an investment.
  10. Labor force refers to the people of working age who are able and willing to supply labor at the prevailing market wage rate.

Appendix

World’s oil prices from 1975 to 2008  Sourced from: http://www.dallasfed.org/research/eclett/2008/el0805.html
Figure 1: World’s oil prices from 1975 to 2008 Sourced from: http://www.dallasfed.org/research/eclett/2008/el0805.html

References

Maura, 2008. High energy costs hike consumer prices in July; inflation up. Web.