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Output gap and commondity prices-

by on 21/07/2013

The main problem of output gap is its focus on unemployment and the interest rate. It is not very surprising that most of the economic models are focused in these two issues, if we remember the 1929 crisis, during which the economic leaderships of the time failed to prevent unemployment of horrendous size, with catastrophic historical consequences. Since then the main aim of macro economist is to prevent anything similar to happen again. However, if the model of output gap is focused too much on the unemployment, it naturally neglects other limiting factors of the output. Then what if the economy reaches its production limits not because of limited aggregated demand and not because of limited labor force, but because of other limited resource, for example energy and let’s assume in our model the supply of the energy is with very limited flexibility (as in reality it is). Any policy trying to stimulate the economy will case immediate energy prices increase and with it the whole economy will be balanced at higher price levels. Nevertheless, increased energy prices will be necessarily followed by increase of production costs. Now since the wages and the profit remain in the economy unchanged, the aggregated demand will remain at its nominal level, previous to the energy price increase. The result will be decrease of the aggregated demand in real prices. Yet do not forget the energy price increase necessarily caused price increase and central bank as reaction to it will probably rise the interest rate, even if the aggregated demand in real values will be in declining trend. The phenomena of stagflation comes to life, and no Philips curve will help here.

World Oil Prices 1970-2008.PNG


The two graphs above show obvious correlation between the oil price and the unemployment. As to the inflation, it is in no correlation with the unemployment and the oil price since 2008, yet it is in correlation at previous energy crises of 1973 and 1979-1980. What can be the reason to this inconsistency? Probably that the oil price is not so crucial as it used to be in the seventies, as it can be seen in the following graph. At 1980 the oil supplied about 50% of all the energy while at 210 it dropped to 30%.

World energy consumption by fuel type Source: 1965-1979: BP Statistical Review of World Energy (2008) (excludes wind, geothermal and solar energy); 1980-2030: U.S. Energy Information Administration International Energy Outlook (2008).

Does it mean there is no danger of a new stagflation as it happened in the seventies-eighties? To my opinion such a danger still exists, since the energy is not the only economic resource that can become scarce. Before the 2008 economic crisis the prices of many commodities raised immensely as seen in the following chart, yet this price hike was short lived because it started at 2006 and with 2008 economic crisis the prices collapsed again. But since 2009 the commodity prices started to rise again and if this trend will continue, probably the phenomena of the stagflation of the seventies will be back, unless some new technology will help to create supplement to the traditional basic resource.

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