On oil price shocks

I was prompted by Julie's post to throw out a little macroeconomic assessment of our new pain at the pump.

If we think of our economy having a certain fixed capacity to pay for things, then as the prices of things go up, we'll buy fewer things. Given everyone's current income right now, if Big Macs suddenly cost $10 and Gas is $3/ gallon, people will drive less and eat out less. They'll spend the same, but consume fewer goods and services.

So an unexpected rise in prices leads to less consumption of goods and services, which means the economy slows down. When firms find they are selling less, they cut their production levels, which means they cut their headcount. So unemployment goes up. When unemployment goes up, increased competition for jobs means new hires make less, which means firms have lower costs. When firms have lower costs, they can lower their prices, and people can consume more. So things will right themselves in the long run, but it requires a recession to fix it.

But recessions suck. The hoi polloi has this nasty tendency to vote out incumbents when the economy goes through a down cycle. So with an economically inhibiting event, like a price spike, the government might hope to counter with an economically stimulating move, like lowering interest rates or increasing government spending.

The good news about these moves is that they may avoid a recession. When the government spends more, the dollars the government spend get passed on as the folks who received those extra dollars first turn around and spend them on other stuff that they wouldn't have spent before. This increases the total demand for stuff in the economy, which is good, except that it hasn't changed the economy's ability to meet the demand. So when demand outstrips supply, prices go up. Which is exactly the problem we're trying to fight. And this is the bad news. So the economy may grow, but prices might rise as fast or faster than the growth in the economy, and we get "stagflation": Rising prices, but stagnant output. So in this case, wages might go up, but with the inflation, real wages might not change at all.

Or, the Fed could be nice with Interest rates. But easy money stimulates borrowing and investment and jobs and spending, which also lead to more demand. And again, we'll get rising prices, as the greater liquidity permits the same volume of transactions to be conducted but at higher price points. So here, salaries rise to "compensate" for the price increases, but since all the prices rise, it may not really balance out the change.

So a price shock does suck. But it only sucks as much as people let it impact their spending habits. And it takes a long time for wages to catch up with price changes. And an employer is going to demand higher productivity for those wage increases...

The best solution is for everyone to go buy a hybrid. We'll be more productive while consuming less gas, but keeping spending constant.