Will High Energy Prices Limit Economic Recovery? Or High Interest Rates?

As the global economy expands, folks are worried about higher energy prices. There's also some concern about higher long-term interest rates. One could also find worry about freight rates, industrial commodity prices, and any number of other prices. Should business leaders be worried?

To understand why I am not worried about higher prices limiting economic growth, let's recall the basic supply and demand from your first economics class. You remember that, right?

(Let's review the basics. The demand curve (red) slopes downward, showing that at lower prices, a higher quantity will be demanded by buyers. The supply curve (blue) slopes upward, showing that higher quantities of production require higher prices. The intersection is where supply equals demand. The price is P1, and the quantity produced and sold is Q1.)

When the demand for a product or service increases, we depict that by moving the demand curve to the right. The new intersection is at a higher price. One might be tempted to wonder about whether the higher price chokes off demand. Well, go to that first equilibrium. Now move directly to the right until you reach the new demand line. That's the pure increase in quantity demanded. But at this price, demand exceeds supply. So the price rises. Now move along the new demand curve toward the new equilibrium. This is where the demand is being limited by higher prices. But there are two fundamentally important points here:

1. The price rises only because demand increased
2. Even with some limitation of demand by the price increase, the total quantity produced and sold is higher than in the initial situation.

How does this apply to today's world (as of February 2011)? Energy prices are up due to the growth of the global economy. That's good. More energy is being used by the larger economy. The higher price rations the limited amount of energy available. The world economy would certainly be even larger if energy were more abundantly available, but that's not a very relevant point. Even though energy prices have risen, the economy is still growing.

The same analysis applies to interest rates. Long-term rates have risen because of an increase in global demand for credit. Even though interest rates are up, the global economy continues to expand.

Note that this analysis would be wrong if the trigger for the price increase was a reduction in supply. That could occur from an oil supply disruption. However, that's not what happened.

So of all the things you could possibly worry about, move this one to the bottom of your list.

 

 

 

Comments

[Lee]

You are correct that growing demand has caused an increase in prices per your graph. However we have to consider the risks of supply disruptions when assessing the effects of price on growth. There are factors that could limit supply. One example is the unrest in the Middle East. Libya recently called a force majeure on exports of 1.5 mb a day of oil (approx 2% of global production). Unrest could cause even bigger oil disruptions if it spread to Iran or Saudi Arabia. The March WTI (oil) contract shot up 8.6% to $93.57 since its close on Friday. Another example is flooding in Australia that has lessened coal supplies. These are just two examples but these types of risks need to be considered since they could impact growth by limiting supply (increasing supply costs).

Also, you are looking at global growth as a whole. The growth of one region or country such as China could push up prices globally. Their growth would push the demand curve out and therefore increase prices. The other countries would then experience higher prices as if the supply curve had shifted up. These shifts would not be a problem for growth in China however they would limit growth/recovery in other countries.

[Phil Aust]

I agree with Lee. If you look at the world as one economy, higher prices because of higher demand isn't a bad thing.

But if you have higher prices in the U.S. because of higher demand in China or a supply shock, the result is the same. The supply curve available to the U.S. shifts to the left (higher prices for each quantity supplied) Since the US is a net importer of energy, this will result in a higher U.S. trade deficit and reduced real income in the U.S. consumer because of higher energy costs.

[Jesse]

I'd make the point that we don't have an economic recovery. We do have however symptoms of an economic recovery as a direct result of Government and Fed interventionist policies.

Without...

- changes to mark to market accounting regulation
- Fed Bond Purchase Program
- trillions of newly created dollars injected into markets
- foreclosure moratoriums
- bank bailouts
- homeowner bailouts
- artificial consumer spending

we would not be talking about a recovery. The interventionist policies just continue to do more of the same. Artificially boost GDP numbers giving the world the illusion that we are recovering when the US economy has not changed from a fundamental perspective .