The article titled “Spectre of inflation” was posted on 7 March 2011 by The Star Online. It reports the impact of rise in world oil prices and explains how this affects the country.
With the world oil prices increasing rapidly, the public is concerned about the effects to the economy of Malaysia in 2011. According to early experiences, the rapidly increasing prices of oil and gas usually affect the country’s economy growth.
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The aim of this report is to examine the impact of the rise of world oil price in Malaysia using economics concepts and simple diagrams. The report will emphasize on macroeconomics, including topics such as inflation, business cycle, aggregate demand and supply, monetary policy and fiscal policy. At the end of the report, a summary of all the discussions mentioned will be concluded.
3.1 Business Cycle
The consistently oil price changes has a great impact on the business cycle. The emerging increase in the world oil price delays the recovery of economy in Malaysia. The effect of the business cycle on oil price changes is illustrated using movements in real GDP. Generally, each business cycle has two phases: A contraction and expansion and two turning points: A peak and a trough. Figure 1.1 shows a hypothetical business cycle.
According to Mahbob (2011), the booming price of oil and gas is not positive for the economic growth as Malaysia is just trying to recover after the global financial crisis in 2009. This will lead to recession. Recession usually decreases the inflation rate. This is an exception because the recession is caused by a supply shock. During this period of time, the inflation rate of Malaysia rises rapidly. Eventually, this increases the unemployment rate and causes the real GDP to fell significantly.
3.2 Aggregate demand
In the article, it was mentioned that the public have to arrange their spending and pattern of consumption due to inflation. The public are encouraged to increase domestic food production, economized on travels and increase usage of public transports to promote household savings (Mahbob 2011). This will help Malaysia to tame the inflationary stress.
Aggregate demand (AD) curve shows the relationship between the price level and the quantity of real GDP demanded, ceteris paribus. The aggregate demand curve is always downward sloping. This is due to a decrease in the price level increases the quantity of real GDP demanded.
Meanwhile, the short-run aggregate supply curve (SRAS) shows the relationship in the short-run between the price level and the quantity of real GDP supplied by the firm.
The aggregate demand curve also shows the equilibrium level of real GDP. The total spending is equivalent to the total output for each price level. The equation of aggregate demand is shown in Figure1.2 as below:
The aggregate demand curve will shift if any variable changes other than price level. A change in C, I, G or net Xs will shift the aggregate demand curve. For example, the increase in price of oil causes the households and firms to become pessimistic about their future incomes. They are more likely to save. This will decrease the overall consumption and hence, shifting the aggregate demand curve to the left.
To help to ease the inflationary pressure in Malaysia caused by the continuously increasing oil price, C, I, G or net Xs should be increased. The aggregate demand curve will shift to the right from AD1 to AD2 in Figure 1.3 if C, I, G or net Xs are increased.
3.3 Aggregate supply
The aggregate supply (AS) curve shows the effect of changes in total output or real GDP on the price level.
The long-run aggregate supply (LRAS) curve is when the real GDP equals to potential GDP and there is full employment. The long-run aggregate supply curve is always vertical because potential GDP is not affected by the price level.
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An unexpected change in the price of natural resources such as oil will shift the aggregate supply curve. For instance, a sudden increase in the price of oil in Malaysia causes supply shock to happen. The price levels of the outputs increase significantly as a greater amount of inputs are needed for production. Costs of producing output rise. This cause the aggregate supply curve to shift to the left, from AS1 to AS2, as shown in Figure 1.4.
Inflation is generally defined as “a process of continuously rising prices, or equivalently, of continuously falling value of money” (Laidler and Parkin, 1975, 741).
Inflation rate is the percentage rise in the level of price every year.
The price of Ron97 petrol was increased to RM2.70 per litre at 1 April 2011, which is RM 0.20 higher than the price before. In 2011, current high oil prices are actually caused by the fears that supply would be disrupted by the unrest and turmoil in Libya and Egypt and the protests in the Middle East. The persistent increase in the price of oil in Malaysia contributed to inflation.
Malaysia, who is experiencing high inflation rate, will cause the real income of individual to decrease. This will then decrease the purchasing power of consumer and weakens Malaysian currency. In long term, Malaysia will experience a decline in economic growth.
According to the economics theories, the increase in prices of oil is a cost-push inflation. Cost-push inflation is defined as “the inflation that arises as a result of a negative supply shock-that is, anything that causes a decrease in the aggregate supply of goods and services” (Essential of Economics, 2010, 465). The soaring oil price causes a negative supply shock, which leads to an upward shift in price level and lower real gross domestic product (GDP) in the short run.
An increase in oil price causes an increase in the production costs. This shifts the aggregate supply curve to the left, from SRAS1 to SRAS2 in Figure 1.5. This moves the short-run equilibrium from point A to point B. The real GDP falls below its potential level and the price level increase from P1 to P2.
3.5 Monetary Policy
The rising oil prices contributes to a big part of the increase in inflation rate in Malaysia. In Malaysia, monetary policy is determined by Bank Negara Malaysia. The aim of monetary policy in Malaysia is to attain price stability of the currency. By maintaining low inflation, it helps to promote long-term growth and full employment. Bank Negara Malaysia implements open market operations (OMO) to sterilize liquidity changes in the overnight money market to maintain constant cash rate.
As shown above in section 3.2, AD = C + I + G + X-M. An increase or decrease in the interest rate will affect the consumption (C), investments (I) and net exports (X-M). However, it does not influence government purchase. For example, an increase in the cash supply on the OMO will lead to a fall in interest rate and an increase in consumer and investment expenditure.
During inflation, Bank Negara Malaysia implements contractionary monetary policy to keep the rate of inflation low. Bank Negara Malaysia increases the cash rate at inflationary periods to decrease the cash supply. As a result, interest rate is increase. This will then decrease the investment, consumption and net exports. The aggregate demand curve shifts to the left. Price level and real GDP are decreased.
As shown in Figure 1.6, Bank Negara Malaysia prevents the aggregate demand to increase too rapid by raising the interest rates. The contractionary monetary policy shifts the aggregate demand curve from AD0 to AD1. The price level decreases from P0 to P1 while the real GDP decreases from GDP0 to GDP1. This helps to reduce inflation.