ChainWhat it assumes · how to break it
Start
World oil prices rise sharply, as in the 1970s oil shocks or when energy prices surged in 2022 after Russia's invasion of Ukraine.
1
As a result, firms' costs of production rise, because oil is an input into fuel, transport, plastics, chemicals and much electricity generation.
costs of production · raw materials
costs of production · raw materials
Assumes: Oil is a significant input for most firms.
But: Service-sector firms such as banks and software companies use little oil directly, so their costs rise much less than those of airlines or hauliers.
2
This means the short-run aggregate supply curve shifts to the left, as firms need higher prices to supply the same output.
short-run aggregate supply (SRAS)
short-run aggregate supply (SRAS)
Assumes: Firms pass the higher costs on in prices.
But: Firms facing strong competition or price-elastic demand may absorb part of the rise in their profit margins.
3
Consequently, the general price level rises: cost-push inflation. Petrol and household energy bills also rise directly, and these carry a large weight in the CPI basket.
cost-push inflation · CPI
cost-push inflation · CPI
Assumes: Demand for oil is price inelastic in the short run.
But: Over time firms and households switch to more efficient vehicles and other energy sources, so demand becomes more elastic and the price may fall back.
4
Therefore, workers bargain for higher wages to protect their real incomes, which raises firms' costs again and can create a wage-price spiral.
wage-price spiral · inflation expectations
wage-price spiral · inflation expectations
Best link to attack
Assumes: Workers have the bargaining power to win compensating pay rises.
Assumes: Workers have the bargaining power to win compensating pay rises.
But: Trade union membership is far lower than in the 1970s, and if the central bank is credible, inflation expectations stay anchored, so second-round effects are smaller.
End
The price level rises through cost-push inflation, and inflation may persist if wage rises feed back into costs.
Evaluation chain
- E1However, the size of the wage-price spiral depends on whether workers can win pay rises that match the higher prices.
- E2If union membership is low and the central bank is trusted to bring inflation back to target, then workers expect inflation to fall and accept real wage cuts.
- E3As a result, second-round effects through wages are small, and inflation peaks and falls back once oil stops rising.
- E4So an oil price rise causes a short burst of inflation that fades, rather than persistent inflation, in an economy with weak wage bargaining and credible monetary policy.
Another way to attack it: If the central bank raises interest rates to stop second-round effects, demand falls and inflation is lower, but at the cost of slower growth. An oil shock is also a one-off rise in the price level: once prices stop rising, measured inflation falls back unless wages keep chasing prices.
The direct effect on petrol prices is almost immediate; the effect through wages and other prices builds over the following year or two.
Can you say this chain from memory?
Members can hide the links, test themselves and track which chains they have mastered.
Practise this chainMembers can hide the links, test themselves and track which chains they have mastered.
Questions this answers
- Explain how a rise in world oil prices could cause cost-push inflation.
- Assess the likely impact of a sharp rise in energy prices on the rate of inflation in the UK.
- Discuss whether a central bank should raise interest rates in response to an oil price shock.
Diagram
AD/AS diagram: SRAS shifts left, the price level rises and real output falls along the AD curve.
Reverse and related
Fall in world oil prices → firms' costs fall, SRAS shifts right and inflation falls, possibly below target.