This paper focuses on the recent increase in oil prices all over the world, when there is an increase in oil prices there is high possibility that this will increase the prices in the entire economy. According to MSNBC article available at http://www.msnbc.msn.com/id/12400801/ the price per barrel of crude oil rose to 128 dollars, this has a negative effect on an economy due to the dependency of oil in the production process either directly or indirectly. A similar crisis occurred in the year 1973 to 1985.
Effects of increasing oil prices on the economy:
When oil prices rise the economy experiences an external shock, a shock can be disastrous to an economy because in most cases the occurrence is not usually anticipated and therefore the economy is nor prepared for the price change. Oil is widely used in every industry in an economy, some countries import oil from oil producing countries, when the price of oil increase the oil importing country experiences a rise in the cost of imports, when import prices rise than the export value then there is an occurrence of unfavorable balance of trade leading to trade deficits.
Trade deficits experienced by countries lead to increased debt problems especially to the developing countries that heavily depend on imported oil. The debt problems will be experienced due to the rise in the oil prices and this will lead to a decline in the performance of the global economy.
A country that imports oil will also experience a rise in the prices of good and services in the entire economy, oil is used as an input in almost all the industries in the economy and when the price rises then the industry will transfer the cost burden to the consumer by increasing prices, when prices rise the economies of the world are likely to experience crises in that they will formulate policies to avoid the rise in price levels in the economy.
From the Phillips theory of inflation and unemployment the cost of reducing inflation in an economy is unemployment and that the cost of reducing unemployment is inflation, for this reason therefore an economy that will aim at reducing inflation caused by oil prices will lead to increased levels of unemployment.
Monetary policy makers will increase the interest rate to avoid inflation, interest rate is the opportunity cost of borrowing funds and when the opportunity cost rises less funds will be borrowed for investment purposes, this will lead to a decline in the investment levels in an economy and because investment provides employment then a decline in investment levels will lead to less employment.
Unemployment caused by the increased oil prices will lead to a decline in an economies per capita income. This means that some individuals will not have income to spend and therefore the aggregate demand in the economy will decline.
Fiscal policies are those policies that include government spending and taxation, when inflation is experienced in an economy the government is likely to reduce spending to curb inflation pressure, reduced spending therefore will lead to increased unemployment.
The oil exporting countries however will benefit from the increase in oil prices, this is because the exports will have more value than the imports and therefore they will gain from trade, the oil exporting countries will also experience favorable terms of trade which will lead to more benefits.
From the above discussion therefore it is clear that the increasing oil prices will lead to negative effects on the economies worldwide. Some of these negative effects include increased unemployment, rise in prices and increased balance of trade and the debt problem.
There is a need to introduce other sources of energy resources to avoid the effects of increasing oil prices, this will also help in the protection of the environment from pollution cased from the use of crude oil, recent research and discovery have led to invention of hybrid cars that use electricity as a source of power, other energy sources include nuclear energy which can be used to act as a substitute to crude oil energy.
From the above it is clear that the increased oil prices will cause a negative effect on the economy, it is clear that increasing oil prices lead to inflation, unemployment, reduced per capita income, increased debt problem and balance of trade.